No matter how prepared an investor can be before buying into a market, there is always a chance of bad luck — or bad timing. There is no guarantee the planets will align themselves to ensure every penny spent is earned back within the expected timeframe, and investors who decide to go with a floating rate are especially at risk. While a floating rate can save you money in the long run, it’s more volatile and dynamic in the market, especially when applied to commercial real estate.
Many financial advisors will tell you to turn away from a potential asset if the market timing isn’t right. But if you’re looking to invest in a property no matter where the market may be, there is a way for you to protect your floating rates in case something happens. Interest rate hedging can help by partially eliminating your risk, leaving you and your lenders both feeling secure.
Hedging your rates can come at a cost, however, and it’s important to understand what you’re getting into before making a commitment. Here’s what you need to know about interest rate hedging in commercial real estate, and how you, too, can protect your assets.
What Is Interest Rate Hedging in Commercial Real Estate Investing?
Like wearing a bike helmet or getting to a job interview early, interest rate hedging is all about anticipating problems and preparing for the worst case scenario. It’s the practice of reducing and controlling an investor’s exposure to risks when acquiring a new asset in a dynamic market.
For commercial real estate, the main concern is in floating bridge loan interest rates that can expose investors to circumstances that can inflate their expected costs on a new acquisition. This type of risk can put a real estate investor’s whole portfolio at stake. Chris Moore, the Managing Director of Hedging and Capital Markets at Chatham Financial, said hedging strategies are especially important for anyone using debt to finance their assets. “Investors with floating rate loans based on indices… will see their interest expense rise as short-term rates increase,” especially because base rates like SOFR and LIBOR are so closely correlated with federal policy.
Investors have to find ways to combat the possibility of rising interest rates, mostly through making other investments to offset the risk of being bombarded with unexpected extra fees. The most common ways to do so are through various strategic instruments that are targeted and controlled by hedge providers. Registered investment advisors recommend considering interest rate caps and interest cap swaps as ways to mitigate commercial real estate market risk.
Interest Rate Caps
An interest rate cap puts a virtual ceiling over your interest rate so that, at an agreed upon rate with a hedge provider, your floating interest rate becomes a fixed interest rate. This deal means that, in a fluctuating market, your interest rate will still warrant a risk, but only to a certain level.
If you’re interested in an interest rate cap, you first have to consider how much risk your asset is currently at and how much you would be willing to spend to protect your rate. Rob Beardsley, a Principal at Lone Star Capital Group, said, “An investor must decide how much risk he or she can tolerate or analyze their investment to see how high of an interest rate the investment can support in order to determine the ‘strike rate’ (ceiling) of the interest rate cap.”
If you have a floating interest rate, but make a deal with a hedge provider to cap your interest rate to 2.5%, you’re protected even if LIBOR quickly increases by 5%. Whoever sold you the interest rate cap would take care of the extra 2.5%.
However, this safety net can come at a cost.
“The cost of the interest rate cap must also be considered as lower caps cost more than higher strike caps,” Beardsley said.
In this situation, the hedge provider is acting like an insurance company and expects you to still pay the deductible — that 2.5% that you agreed to before LIBOR rose — even if your financial situation and loan agreements with other lenders change. If you don’t pay, then your agreement is off, and you’ll end up in more debt than you were with just your original bridge loan.
Interest Rate Swaps
Taking on an interest rate swap agreement is your chance to switch out your rising interest rate for a fixed one when the market’s not working in your favor. To avoid paying rising rates to a lender in a variable base LIBOR market, a bank can offer a swap so you pay the fixed rate to them and they will pay you back the LIBOR rate to pay your lender.
Beardsley described this hedging strategy as a true trade. “Swaps eliminate interest rate risk by utilizing a third party counterparty to ‘swap’ the investor’s floating rate payments for fixed rate payments,” he said. The fixed rate to the bank is your net cost of funds.
Interest rate swaps protect against rising rates at no extra premium. However, no matter the base rate during the life of your swap with the bank or hedge provider, you will always pay that fixed rate — even if LIBOR goes back down. Once you accept the fixed rate, it will not change for the duration of the agreement.
If the base rate is lower than the fixed rate, you owe the bank the difference. You might have several loans that are considered in the single swap transaction, but there may be a breakage cost if you end the agreement early depending on market conditions at the time.
Example of Interest Rate Hedging
Let’s say you’re acquiring a new commercial real estate investment and decide to start off at a floating interest rate, because your market’s LIBOR is currently at 0.10. However, the LIBOR base rate is predicted to rise up to 5% within the next few years, and you want to protect your asset from astronomical interest rates. To save money down the line, you need to look into interest rate hedging products.
Your initial loan agreement with your commercial lender dictates that you pay the variable base rate of 0.10 to reflect LIBOR plus a 2% lending margin. When LIBOR increases, the total interest you pay the lender rises with it, increasing the payments over the course of your loan.
You decide to investigate your interest rate hedging options by meeting with a hedge provider, who then recommends you acquire an interest rate cap at 3%. When the time comes for LIBOR to rise as expected to the forecasted 5%, you only have to pay a 3% interest rate, and the hedge provider will take care of the rest.
Best Practices for Interest Rate Hedging
Instead of refinancing your loan when the going gets tough, purchasing a hedge product can reduce your risk to both your real estate property and your portfolio. But before you decide to approach a hedge provider, you need to consider the type of risk they might encounter in your loan agreement. This assessment includes your own risk tolerance, the correlation between the asset’s income and interest rates, and your sensitivity to prepayment penalties.
Simpler strategies are often better than more complicated ones. Moore said that an investor should start thinking about risk while still in the underwriting phase. ”Interest rate risk is a real risk, particularly in the current environment, and hedging that risk has real costs,” Moore said. “Considering that risk and how to mitigate it after you’ve already underwritten and signed up a deal can drive suboptimal decisions.”
The choice of interest rate hedging instrument depends on the investment, too.
“Some investors have a greater appetite for interest rate risk, and some investments may have ‘natural’ hedges,” Moore said.
For example, a multifamily property investor might expect their income to correlate with interest rates, but the owner of the long-term lease office building down the street might not.
Moore said, “Some hedge strategies like interest rate caps introduce no prepayment risks, while others like interest rate swaps may.”
Is There Such Thing as Perfect Interest Rate Hedging?
Moore argued that yes, perfect hedging is possible. “Any investor hedging a floating-rate loan should be targeting a ‘perfect’ hedge, where changes in cashflows on the loan are exactly offset with changes in cashflows on the hedge.”
But this is still an ideal situation, and can’t be guaranteed for every investor. There are always cost tradeoffs when investing your money in commercial real estate. Because of this dynamic, be sure to follow your lender’s hedging requirements and speak with your financial advisor about your options before diving in.