In loan negotiations, many zero-sum games remind the parties that they are on opposite sides. Defining the reference interest rate over which the margin applies isn’t one of them, but, as recent market turbulence shows, this term carries a lot of value to both parties. For fixed-rate or floating-rate loans, this rate can change rapidly (see table).
Reference rate risk is the extent to which short-term interest rate shifts make term-sheet assumptions inappropriate at completion. Proper underwriting requires an all-in interest rate assumption to calculate loan risk. Margin is fixed, but the reference rate might not be known for weeks. At completion, a lender would benefit from a lower-than-underwritten reference rate, as more of the cash generated by the asset is available for debt service, reducing loan risk. The opposite is also true.
Zero-sum game enthusiasts might see this as an excuse to renegotiate the margin in the closing process, but the reference rate is a moving target. Instead, standard practice is for lenders to build tolerances into underwriting assumptions so key economic terms are not revisited.
Thus borrowers do not gain from a fall in the reference rate and are not punished if it rises. They only have to “buy down” the rate if the all-in rate rises beyond agreed tolerances.
Borrowers accept lack of margin flex, as it is a two-way street, and understand the need to keep the all-in rate below a certain level. But savvy borrowers would cringe if hard-fought margins were padded for a “margin of error” related to reference rate risk.
This is not a theoretical risk. In the past 10 years, the incidence of a 25 basis point shift in a five-year reference over any given five-week period has been 20%, 28% and 34% for euros, sterling and US dollars, respectively.
While a 25bps move would only have a material impact on the tightest of financings, it is significant from other perspectives. Few UK borrowers would accept a one in four chance of their margin moving 25bps between signing and completion.
Investors in many sectors often consider removing reference rate risk, if an efficient means is available. More real estate borrowers would use such hedging if confident that any costs were accompanied by a margin without a “margin of error.”
Although applicable to fixed- and floating-rate loans, the impact on floating-rate loans manifests through hedging costs which, depending on the strategy, may not have a 1:1 correlation with rate movements.
If the borrower chooses a swap (where hedging costs are borne in the fixed swap rate payable),there is virtually no difference. If a borrower adopts a cap strategy, the higher or lower cost of the cap would change in a non-linear fashion depending on its strike rate and other factors.
Lenders and borrowers working together to address this risk is known as pre-hedging. Full co-operation is admittedly tricky, as zero-sum games still take place between signing and completion. But two short-term hedging alternatives should be viable.
The first is to fix the reference rate, using a forward-starting interest rate swap. This removes the risk at no up-front cost, but the catch is that it requires ultra-high deal certainty, given the settlement risk if the deal is not completed.
The second alternative is to limit the reference rate. The underlying deal would be a swaption – an option on a forward-starting swap. This only limits the risk of a rising rate (or total hedging costs, depending on the strategy) to a defined worst case. Lenders can facilitate by deferring the premium until completion.
The various facets of interest rate risk are more front-of-mind when radical shifts in interest rate expectations take place, as they have recently. As competition for real estate lending intensifies in a volatile environment, the potential grows for more finely-tuned and co-operative hedging strategies.