Presenting a live 90-minute webinar with interactive Q&A Swap Documentation in Real Estate Loan Transactions: Coordinating ISDA Master Agreement and Loan Agreement Terms Documenting Covenants, Security, Required Consents, Voting and Control, Reporting, and Regulatory Issues WEDNESDAY, OCTOBER 26, 2016 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: Eddie Frastai, Partner, Clifford Chance , New York Jeffrey Koppele, Partner, Dentons , New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .
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Swap Documentation in Real Estate Loan Transactions: Coordinating ISDA Master Agreement and Loan Agreement Terms Strafford Webinar October 26, 2016
Introduction [Eddie to supply picture] Jeffrey H. Koppele Eddie Frastai Partner Partner Capital Markets/Tax Real Estate Dentons Clifford Chance LLP D +1 212 768 6916 D +1 212 878 4931 jeffrey.koppele@dentons.com eddie.frastai@cliffordchance.com October 26, 2016 6
Agenda • Introduction: Interest Rate Risk in Real Estate Financings • Hedging Interest Rate Risk: Rate Caps and Interest Rate Swaps • Integrating Hedge Agreements Into Loan Documentation • Regulatory Issues: Dodd-Frank • Negative Interest Rates October 26, 2016 7
Interest Rate Risk in Real Estate Loans • A commercial mortgage loan often bears interest at a floating rate. • Floating rates can rise quickly at any time. • Rental income of the property owner/borrower generally changes gradually. • A spike in interest rates is thus a risk for borrower (and lender). October 26, 2016 8
Mitigating Interest Rate Risk • Lender often requires borrower to mitigate the risk of interest rate volatility. • A hedge is a form of "derivatives contract." – Derivative: an agreement whose value is derived from the value or amount of an underlying index, asset or event. – Here the index is an interest rate, usually 1-, 3- or 6-month LIBOR. October 26, 2016 9
Rate Cap • The most common hedge in commercial real estate finance is a rate cap. • Borrower purchases rate cap from a counterparty, usually a bank ("Rate Cap Provider"). • Borrower pays to Rate Cap Provider a fixed amount at the inception of contract. • Rate Cap Provider pays to borrower the excess, if any, of LIBOR over a specified Strike Rate, periodically over the term of the contract. Rate Cap cashflows: LIBOR - Strike Rate Cap Borrower Provider Fixed Upfront Payment October 26, 2016 10
Rate Cap • Lender determines the strike rate for the Rate Cap, based on the property's expected cashflows/interest coverage. • Rate Cap sets a cap on the Borrower's effective interest rate under the loan. • Rate Cap and Loan periodic cashflows: Loan: Rate Cap: X X Rate Cap LIBOR + Spread LIBOR - Strike Lender Borrower Provider • Rate Cap Provider pays the excess of LIBOR over the Strike rate. • Borrower's effective interest rate is capped at Strike + Spread. October 26, 2016 11
Borrower Cost Capped Whether LIBOR Rises or Falls • Facts – Loan interest rate: LIBOR + 1% – LIBOR at closing: 2% – Strike Rate on Rate Cap: 3% – Borrower net cost capped at Strike + Margin 4% • If rates go up, Rate Cap proceeds fund Borrower's increased LIBOR cost. – Example: LIBOR increases to 4% □ Borrower pays Loan interest rate: 4% + 1% = 5% □ Borrower receives from Rate Cap Provider: 4% - 3% = 1% □ Borrower net borrowing cost: 5% - 1% = 4% – Example: LIBOR increases to 6% □ Borrower pays Loan interest rate: 6% + 1% = 7% □ Borrower receives from Rate Cap Provider: 6% - 3% = 3% □ Borrower net borrowing cost: 7% - 3% = 4% October 26, 2016 12
Borrower Cost Capped Whether LIBOR Rises or Falls • Facts – Loan interest rate: LIBOR + 1% – LIBOR at closing: 2% – Strike Rate on Rate Cap: 3% – Borrower net cost capped at Strike + Margin 4% • If rates go down, property cashflow funds Borrower's Loan interest rate. – Example: LIBOR decreases to 1% □ Borrower pays Loan interest rate: 1% + 1% = 2% □ Borrower receives from Rate Cap Provider: 0% (LIBOR less than Strike Rate) □ Borrower net borrowing cost: 2% October 26, 2016 13
Disparate Objectives of the Parties to Rate Caps • Lender – robust cap • Borrower – minimize cost • Rate Cap Provider – high-volume, low-profit transaction • Parties' disparate objectives can and frequently do result in risks for the Lender and Borrower. • Many of these risks are avoidable. October 26, 2016 14
Rate Cap Provider Downgrade • Rate Cap Risks – Cap Provider bankruptcy or insolvency • Rate Cap typically includes a "downgrade" provision: – Cap Provider credit rating must exceed a specified threshold at closing. – If Cap Provider rating drops below a specified trigger, Cap Provider must either post collateral or replace itself. – If Cap Provider rating drops below a second trigger, Cap Provider must replace itself (and must post collateral until replacement is accomplished). October 26, 2016 15
Advantages and Disadvantages of Rate Caps Advantages Disadvantages • • No ongoing borrower payment Rate cap requires upfront obligations (after payment of premium upfront premium) • • Borrower benefits from decline in Cost increases with duration floating rate • • Typically assignable by borrower Rate caps typically limited to three years • Borrower may receive, but will never be obligated to make, a termination payment. October 26, 2016 16
Interest Rate Swaps • An interest rate swap converts Borrower's floating rate obligation to a fixed rate. – Borrower makes periodic payments to swap provider at a fixed rate. – Swap provider makes periodic payments to Borrower at LIBOR. – Payments are netted; party with the greater obligation pays the difference. -------- Loan -------- X LIBOR + Spread Lender/Swap X Borrower LIBOR Provider Fixed Rate -------- Swap -------- October 26, 2016 17
Interest Rate Swaps • If LIBOR goes up/down: – If LIBOR exceeds the Fixed Rate, Borrower receives money under the Swap, but its Loan interest payments are higher. – If LIBOR remains below the Fixed Rate, Borrower pays money under the Swap, but its Loan interest payments are lower. • Regardless of LIBOR, Borrower's effective Loan interest rate is equal to the Swap Fixed Rate plus Loan Spread. • Unlike a rate cap, a swap usually has no upfront fixed payment. • Lender may act as swap provider. • Borrower typically pledges its rights under the Swap to Lender as additional collateral for the Loan. October 26, 2016 18
Advantages and Disadvantages of Interest Rate Swaps Advantages Disadvantages • • No upfront payment required Borrower does not benefit from decline in floating interest rate • Longer durations available • Borrower has ongoing payment • Fixed/swapped rate will not obligations. Therefore: change over time – Swap provider typically requires collateral or other credit- worthiness – Two way termination payments possible • Typically not assignable by borrower October 26, 2016 19
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