Now is a good time to protect against possible future interest rate increases. Since March of this year, the 10 Year Treasuries increased over 80 basis points (bps, or 1/100th of a point), but in recent days Treasuries have eased a bit from a peak of 5.31% on June 12th to 5.10%, providing an opportunity to lock-in rates at approximately 20 bps lower than the high for the year. While no one knows for certain, very few market experts expect rates to go back into the mid to high 4’s in the near future, due to a variety of national and international factors including inflation and waning foreign demand for US Treasuries. Because cap rates are generally low, the debt coverage ratio (DCR) is more likely to limit loan proceeds than LTV. Increasing rates can create borrower exposure not just to higher debt costs, but to significantly lower loan proceeds, possibly trapping equity in a project. Projects under construction or financed with a bridge loan are at risk if Treasury rates increase during the term of the interim financing and insufficient proceeds are available to refinance the interim loan.
The traditional approach to manage interest rate risk has been to “lock-in” a future rate with a lender by paying a fee for a forward commitment. In addition to commitment fees, lenders typically add one or more bps to the interest rate for each month. The incremental cost over a 10 year loan term can be significant. In addition, it is difficult to accurately determine the proper loan amount for a future funded loan today, due to uncertainty in lease rates, absorption, etc. By locking-in, the borrower also loses the ability to take advantage of a drop in interest rates at the time of the permanent loan funding.
There are numerous reasons to manage interest rates independently from a loan or from a particular lender:
· Provides more flexibility than a forward commitment, without restrictions to a particular lender, loan program or project.
· If rates drop prior to funding, the loan would be underwritten at a lower rate, hence greater proceeds and lower borrowing costs over the term of the loan.
· Forward swaps offer no practical limit on how far forward protection can be extended; typical rate-lock programs are limited to 18 months
· No project underwriting or appraisals are required. Trades can be put in place within a matter of days limiting short run rate risk.
GSP has formed a partnership with a major investment bank to help GSP clients manage interest rate risk and execute the trades. There are a number of different structures which can be used, each requiring a different level of cash collateral. For example, one could fix a specific rate, set a rate cap, or structure a “forward collar” to lock in a range of rates rather than a specific rate. Many transactions can be structured with no transaction costs to the borrower.
