Slow Rolling Levered Loans Portend More Uncertainty In 2023
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
TLDR:
- Quickly rising interest rates create responses in related instruments used to hedge CRE loans
- Two instruments used for this purpose are rate swaps and rate caps
- Rate swaps are used far less than before the GFC, in favor of caps
- Caps present very real counterparty risk elements, in an environment of quickly rising rates, which could cascade through various channels, should shortened cash flows arising from rate hikes bite harder than anticipated
- Human nature is often to not anticipate properly
- Many investors, especially those with loans nearing maturity are currently opting to extend loans at very high cost, rather than gamble on the uncertainty of being able to refinance at an advantage in the future, which could add fuel to these potential cascades, if and when they were to occur.
- This is neither doom nor gloom, as the US economy is positioned better than any other to absorb these impacts and maintain course; however, there could be crises, and every crisis is an opportunity for those prepared.
Commercial real estate loans tend to be a bit different than residential loans. Lenders and borrowers tend to be more sophisticated, and more aware of options. As such, they can use derivative products to better shape the risk profiles of their investments and their attached financing to their liking.
Depending on prevailing financial conditions, lenders and borrowers may each prefer to transact using either fixed or floating interest rates, which often are out of sync with one another. Because borrowers typically receive income from tenants that are relatively stable and change relatively slowly, they often prefer to pay fixed interest rates. Lenders often prefer floating rates under the same circumstances, as they better facilitate their back-to-back funding requirements.
Swaps and Caps
To get each party what she wishes, financial gymnasts created derivative instruments - contracts, in essence, that derive their value from some underlying asset; in this case, interest rates on the financing of a property.
One such derivative is called an interest rate swap. These contracts allow a lender or investor with a floating or fixed asset or obligation to swap it for the other, for a fee. Rate swaps were a significant contributor to the pain of the 2008 great financial crisis (GFC), as lenders found themselves often unable to enforce covenants due to long-dated swaps which swelled in cost as counterparty risk morphed from an academic, theoretical risk to a very real one. Swaps have since fallen in popularity, in favor of rate caps.
Under a rate cap, a borrower who owes interest on a floating rate basis is typically required by the lender to purchase a rate cap, which acts like a sort of insurance policy. As rates rise quickly, they generate a type of force in the market that can be disruptive if not destructive. When rates rise over a long time period, investors, lenders, and borrowers have more time to adjust. That time is quite valuable, as it turns out.
The Return Of Counterparty Risk
In such a volatile rate environment, counterparty risk becomes very top-of-mind for anyone who witnessed the GFC in all its destructiveness. Loan agreements often stipulate that if certain ratings levels are triggered, then additional collateral must be posted, or the cap must be novated to a different cap provider. We have not been at this rate hike juggernaut long enough to see how this replacement mechanism works under stress, but suffice it to say the risk of it not working is quite large. Should interest covenants fail to give proper credit to the strike rate specified by the cap, this could trigger cascading cash sweeps, or even defaults.
REIT Impact
The potential exists for these cascades to impact the value of Real Estate Investment Trusts, essentially mutual funds that own commercial property, extending them via margin calls, dividend cuts and option executions. Cash flows from recent rate hikes have barely been felt yet at this point, and will likely not be until sometime in 2H 2023, at which point we could be in an entirely different market.
Not Doom nor Gloom
This is not to make a dire prediction, but to point up what many investors are likely to miss as they project current conditions and assumptions onto future ones. Humans have a strange way of not seeing what they don’t want to see, to wit: War, at the turn of the 20th century, was thought to be obsolete by the intellectual establishment. 15 years later, Arch-Duke Ferdinand was assassinated, kicking off World War I. Germany was thought too weakened by it to ever rise again. 20 years later, Hitler invaded Poland. And in the modern era, we have an entire generation of people who do not remember the Cold War or 9/11 or likewise understand that the period of globalized free trade and the low-interest rates that fueled it were but a moment in time, and one that is now ending. How this shakes out is going to impact the rest of the world more than the US, but the US will not be unaffected. Keeping close tabs on these situations is imperative as we move forward because every chaotic element represents both crisis and opportunity.
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