We need to talk about hedging

Calls from concerned real estate clients have been coming into the London office of risk management firm Chatham Financial with increasing regularity in recent weeks as borrowing rates in the industry have steadily increased.

“We’ve had a very large number of calls from infrequent hedgers, and people we hadn’t talked to for a long time,” says Jackie Bowie, head of Europe for the firm, “and it’s down to how much interest rates have moved lately.”

In the past 12 years, ultra-loose monetary policy has meant that few real estate borrowers have wasted any sleep worrying about interest rate risk. Many would opt to hedge floating-rate loans with an inexpensive cap, which sets a ceiling on payments if rates were to rise. For years, hitting that ceiling seemed a remote prospect.

Now, with central bankers raising rates to combat rising inflation, floating-rate debt costs have increased. Per Chatham’s data, three-month compounded SONIA, the floating reference rate for most sterling denominated debt products, increased from 0.12 percent at the start of February to more than 1 percent by the end of July.

The sharp increase, Bowie says, has caught many borrowers unawares. “Over the past 12 years, sponsors have built into their investment thesis an underlying rate of around 1.5 percent, plus margin, and assumptions on levered equity returns were based on that. Now, real estate borrowers are really having to think about their interest rate hedging strategy and how this impacts cost of debt and overall investment returns.”

Hedging costs have rocketed. Bowie says premiums for interest rate caps – which so many in the market use – have increased in the order of five times between January and July, in both the euro and sterling markets.

Afraz Ahmed, head of treasury for Europe at real estate fund and investment manager Cromwell Property Group, says his team were quoted €50,000 for a cap at the beginning of June. “We executed the transaction three weeks later, and from the first quote to execution, the cost went up to almost €200,000 and then settled at €100,000. The challenge is the volatility.”

For many, the choice is whether to stay floating and pay upfront for a more expensive cap to hedge against future interest rate risk, or to opt to fix via an interest rate swap. While caps were most common across the sterling and euro real estate finance markets before the recent rate rises, Bowie says the proportion of transactions now deploying swaps is increasing.

But it is not an easy choice. “The difference between the fixed swap rate and the floating rate is extremely wide,” explains Bowie. “For sterling floating-rate debt, in July, you would pay 85 basis points. To fix it, you would pay 2.6 percent. Borrowers reluctant to lock in that higher rate will instead opt for a cap. But this usually requires an upfront payment and is expensive. Also, some borrowers may not have the cash liquidity to pay the premium.”

Suddenly, real estate borrowers are being forced to give much more thought to their hedging strategies. “Hedging has almost been a non-issue from a borrower perspective for many years,” says Ahmed. “But, if you had worked in finance prior to the global financial crisis, as I did, you’ll realise the past 12 years have not been normal.”

Cromwell has policies and procedures in place around hedging for its various funds, but Ahmed says recent volatility has prompted deeper analysis of the costs. “Swaps and caps pricing has become much more volatile, so that has led to much closer monitoring and internal reporting, to manage interest rate expectations within the company.”

He adds that the company is seeing the benefit of its approach whereby hedging is a legal condition within its financing deals. “Having the ability to make it a condition subsequent of the transaction gives you an extra 20 or so business days once all the work on the transaction itself is done, so you can focus on finding the appropriate
hedging.”

Debt advisers are spending more time of late talking borrower clients through hedging options. Edward Daubeney, co-head of debt and structured finance at property consultant JLL, says the role of advisers is not to predict where rates will move to, but to ensure clients are aware of risk mitigation strategies.

“If they are borrowing from a traditional lender, some borrowers are now electing to take a fixed-rate loan, if possible, or a floating-rate with a swap, which means no upfront cost and allows them to lock down today’s pricing for three to five years,” says Daubeney. 

“In the very low interest rate environment we have experienced the past few years, borrowers have purchased caps because premiums have been so inexpensive. Cap premiums have considerably increased, so clients are taking shorter term caps to keep the cost down, especially if they have a short-term business plan.”

Across the European real estate market, banks have traditionally insisted borrowers hedge at least a large proportion of their debt. Market participants say hedging requirements have been less uniformly applied across the growing alternative lending market. Now, lenders of all types are reported to be working with sponsors to help manage the increased cost of hedging.

Claus Skrumsager, who runs the North Haven Secured Private Credit Fund for the asset management arm of US bank Morgan Stanley, explains a zero percent Euribor cap was the standard hedging tool in the era of negative eurozone rates. “But this is now absolutely something that is being negotiated,” he says.

The aim, Skrumsager adds, is to help minimise the financial burden of hedging to the borrower, by agreeing to a higher strike rate for the sponsor’s cap – making it less expensive due to the reduced likelihood of the provider needing to pay out. 

Three-month compounded SONIA, the reference rate for many debt products, has rocketed this year (%)

Cap rate premiums, for products featuring various strike rates, increased sharply this year* (£m)

“As a lender, we can say to our sponsors, ‘I want you to be protected against Euribor going very high, which could make it difficult for you to service your debt. But I will allow you to strike at a higher rate.’

“The sponsor might say the cost of that cap over five years is still expensive. So, rather than the sponsor buying the hedge for five years, we agree they can buy for three years. We can structure the loan as a three-year facility, plus two one-year extensions, so they are able to finance the asset for the period they need, but they can hedge for just three years, and then subsequently for each additional year. The shorter term of the hedges keeps the cost down.”

Investment manager PGIM Real Estate offers fixed and floating-rate loans across the UK and eurozone. James Mathias, portfolio manager for real estate debt at the firm, says sponsors are spending more time analysing options. “Borrowers often now ask us to quote on both bases, due to their views on short- to medium-term financing costs. They realise deals are increasingly sensitive to the interest rate environment.”

Mathias says lenders’ challenge is to provide financing that helps sponsors meet their objectives, while managing lending risk. “That might mean providing fixed-rate alternatives, or different term structures. Ultimately, we take a risk-based approach to underwriting with different capital sources that can address the funding needs of borrowers, even in challenging market conditions. Across the lender community, debt service is now a bigger driver of lending appetite than it has been, and the total cost of finance has become a big focus as rates increase and hedging costs have become more volatile.”

Exploring options

As well as swaps and caps, some borrowers are exploring other ways to hedge their debt. “With interest rates being so volatile, some borrowers are taking out ‘swaptions’, especially in cases where they need to refinance an asset but know the loan will not close for at least a month or two,” says JLL’s Daubeney. 

“If, when the loan closes, rates have increased, the sponsor is no worse off than the agreed rate, although they will have to put collateral – usually cash – down for it,” he says. “If rates are lower than the option when the loan closes, the borrower hedges at the lower rate and sells the swaption. It means borrowers can sleep at night as rates move around.”

Chatham’s Bowie has seen borrowers explore pre-hedging strategies. She also sees some sponsors that are focused on cash-on-cash returns thinking creatively. “Some might be willing to ‘subsidise’ the fixed rate,” she explains, “so, if the swap rate is 2.5 percent, they will contribute cash upfront to bring the swap rate down. That requires cash on day one, but it means a subsequent rate of 1.5 percent, meaning the sponsor is more likely to have surplus cash with which to make distributions.”

Bowie has also seen sponsors opt to hedge with strike rates well below the current market rate. “They are paying huge premiums on day one for the in-the-money caps, to keep the cap strike rate very low and generate cashflow surpluses. That is a very active way to manage hedging. It is less about managing interest-rate risk than managing ongoing cashflows.”

Some attempts at creative hedging in recent years might leave some sponsors exposed to significant costs in today’s market, Bowie adds. She points to ‘springing caps’ whereby a lender agrees a sponsor need not hedge until rates reach a certain level. Such arrangements may have been tempting to some when rate rises seemed unlikely. But sourcing hedges in today’s market is now a major cost to those borrowers.

Market participants warn against complex hedging products. “I’m sure there will be discussions in the market about exotic hedges with names like collar hedges, extinguishing hedges, knock-out hedges. But I strongly advise sponsors against them – pricing is not transparent, and some don’t work when they are supposed to,” says Skrumsager.

Cromwell’s Ahmed agrees. “My job as a treasurer is to keep things as simple as possible. Swaps and caps are the ways I would go. Banks will offer lots of derivative products; however, the simpler you keep things, the better in the long term.”

A new era

There is huge uncertainty around the future course of inflation and interest rates. But there is a strong possibility real estate borrowers will need to get used to higher debt costs, including the greater financial burden of hedging, in years to come. Many also believe lenders will manage the greater credit risk that comes with higher debt costs by reducing the amount of leverage they are willing to provide. Borrowers may also become reluctant to take on too much debt as the cost of servicing it, and hedging it, increases.

Bowie believes the industry will recalibrate to building in higher debt cost assumptions. She recalls the market before the global financial crisis when underlying rates were typically 4.5-5 percent. “People got used to factoring in an assumption of rates at these levels and all the negotiation was focused on the lending margin.

“Normal rates pre-2007 were far higher than they are today,” she adds, “so, with that perspective, even the increased rates as of today still look relatively low.” 

A look at leverage

While lenders appear willing to negotiate higher strike rates and shorter hedges with sponsors, some believe managing higher hedging costs will ultimately lead debt providers to make less leverage available as they seek to protect their loan covenants.

Claus Skrumsager says allowing higher strike rates for caps exposes the financing deal participants to higher interest costs. “It means when we calibrate the sustained interest coverage ratio, we need to factor in that higher interest cost. Either we need to be convinced the sponsor’s net operating income will cover the additional cost, or we put lower leverage on the loan from the outset.

“For me, as a lender, to get comfortable that the sponsor is not taking on an excessive interest burden, we may have to reduce the loan-to-value to ensure the ICR is acceptable, typically that has reduced leverage by around +/- 5 percentage points.  By reducing the leverage, the higher coupon is paid over a smaller amount of debt.”

Chatham’s Jackie Bowie expects sponsors to seek lower leverage to reduce debt costs and make investment deals work in a market in which yields are low and debt costs are rising. Unless they do, she says, some transactions simply will not make the required return targets.