Negative interest rates implemented by central banks are driving up the costs of real estate lending, the Commercial Real Estate Finance Council (CREFC) Europe has warned.
Negative rates could cause potential mismatches between commercial real estate loans and associated interest rate hedging, the industry body said.
The European Central Bank (ECB) as well as the Bank of Japan are using negative rates to stimulate growth, while Denmark, Switzerland and Sweden are trying the measure to keep their currencies in line with the Euro.
At a CREFC Europe seminar held in London last night (13 April), industry figures warned that commercial real estate investors face new considerations on costs on new financings, plus potential problems which may emerge in historic deals. Specific provision needs to be made, and the associated cost paid, to include an interest rate floor in interest rate swaps, participants in the seminar said.
Interest rate swaps allow a borrower to convert a flexible floating-rate loan into a fixed-rate liability that its rental income is expected to cover. While loan agreements can include a safety net so that floating interest rates stop at zero – in order to prevent lenders having to pay borrowers – many older interest rate hedging derivatives do not do that. A typical interest rate swap would not cater for this unless an interest rate floor is explicitly included in the contract.
“Derivatives play a crucial role in financing by allowing borrowers and lenders to hedge risk, for instance related to interest rates. The problem is that derivatives may not be set up to deal properly with negative rates,” said Adam Dann, partner at law firm Berwin Leighton Paisner, which hosted the event.
Rules set down by the International Swaps and Derivatives Association (ISDA), which is responsible for standardised derivatives agreements, govern how swaps are structured. A ‘plain vanilla’ interest rate swap would not include an interest rate floor, but the position is different when a swap is used to hedge interest rate risk in a loan that does include such a floor.
“A mismatch occurs when borrowers wish to hedge the loan with an embedded floor using a conventional interest rate swap,” said Nadim Mezher, director in global banking and markets at HSBC.
“This is because the floating leg of an interest rate swap does not include a zero percent LIBOR floor, thus exposing the borrower to an increase in the combined financing cost should LIBOR turn negative, in the absence of a zero percent floor in the hedge,” Mezher added.
While including an interest rate floor in an interest rate swap is straightforward, pricing it can be challenging. Mark Battistoni, managing director at risk management advisor Chatham Financial said that parts of the derivatives markets have had a very hard time adapting to negative rates.
“Models need to be revised or scrapped in favour of new ones – in particular for interest rate options such as caps and floors,” he said. “The pace of change varies by banks, so even now, the product capabilities and price differential between mainstream banks for some hedging products is shockingly wide.”
In the lending context, if the reference rate in a floating rate loan falls below zero, the lender will not receive the full margin for which it bargained. If the reference rate moves far enough into negative territory, the lender could, in theory, end up having to pay the borrower interest.
The obvious solution is for the loan agreement to include a zero floor for the interest rate payable, so that the lender never has to pay interest to the borrower, CREFC said. The Loan Markets Association (LMA), which maintains standard form documentation for the loan syndication market, is understood to have recommended the inclusion of such a provision. However, not all transactions are documented using LMA documentation, and older deals may not include a zero floor.
“In some sectors – like the leveraged corporate space which is dominated by institutional debt providers – LIBOR floors have been prevalent at levels above zero for a number of years,” said HSBC’s Mezher.
“Now that negative interest rates have become a reality in some currencies and a possibility in others, many lenders are requiring zero percent LIBOR floors on loans. This is required to protect lenders’ loan margins as some central banks have begun charging banks for excess reserves in markets where policy rates are negative, while banks in general have yet to pass on this cost to their retail and corporate clients,” added Mezher.
Peter Cosmetatos, chief executive of CREFC Europe, said: “There are numerous unintended consequences arising from negative rates. One issue, historically as well as for new deals, is ensuring that both loan agreements and related hedging arrangements all work and fit together as they should. Addressing risks in that area is likely to carry a cost.
“More broadly, our sense is that, while most lenders remain disciplined and responsible, the monetary policy environment is creating perverse drivers and unintended risks in cyclical real estate markets. Crucially, real estate investment has a key role to play in economic recovery across the world. And while only five central banks currently have negative rates, their jurisdictions account for almost a quarter of global GDP, and the international nature of real estate capital flows means that knock-on effects will impact in many markets.”