Here’s the challenge for commercial real estate borrowers: CRE portfolios are increasingly complex. Many of the largest contain a mix of property types. Some are spread out over vast geographic areas. How, then, can borrowers most effectively raise capital while managing financial risk?
Fixed-rate loans, of course, provide cost certainty. But they’re not flexible enough for many borrowers and can cost more than floating-rate loans. But borrowers who rely too heavily on floating-rate debt — while gaining flexibility — may face a level of risk that’s too high.
This is the challenge that Dan Hampton, senior vice president, managing director and head of U.S. commercial real estate with Chicago-based BMO Harris Bank, and Timothy Huang, vice president of financial products with BMO Capital Markets, tackle in BMO Harris Bank’s latest white paper: Hedging Variable Rate Exposure in a Commercial Real Estate Debt Portfolio.
The good news from the report — which you can find here — is that financial markets today provide CRE borrowers with choices that allow them to maximize flexibility while managing debt-service costs and market risks.
In today’s lending environment, a growing number of CRE borrowers are relying on floating-rate loans paired with interest-rate derivatives — in the form of an interest-rate swap or an interest-rate cap — to provide more flexibility and preserve cost certainty. This allows borrowers to source the cheapest form of available capital without exposing themselves to a high level of interest-rate risk.
In an interest-rate swap, a lender and a borrower agree to exchange cash flows according to a specific set of parameters, including principal size, floating index or frequency over a period of time. The cash flows combined with those paid on an underlying floating-rate loan will result in the same cash flows as if the CRE borrower had closed on a fixed-rate loan.
In an interest-rate cap, the lender agrees to reimburse the borrower if interest rates (LIBOR or prime) rise abouve a set level during a specific period of time. The borrower pays an upfront premium to the lender for this protection. A cap, then, acts like an insurance policy against rising interest rates.
The white paper by Hampton and Huang goes into far more detail about how interest-rate caps and swaps can help borrowers find financing for real estate projects. It’s certainly a report worth checking out, especially as commercial portfolios continue to grow in size and complexity.