For a general overview of interest rate swaps and how they work, please read: What is an interest rate swap?
Swap rates and mechanics
- Where can I find swap rates?
- What should I consider in my term sheet to ensure I get the optimal outcome in my swap execution?
- On what types of loans is a swap available?
- Why am I limited to my lender for an SPE-level swap on mortgage debt?
- Is there a difference between basis points in credit charge versus basis points in loan spread if they get you to the same all-in coupon?
- What happens if I have an interest rate floor in my loan? Will it affect my swap?
- If I cannot auction my swap, how does Chatham help with pricing on a direct swap with my lender?
- What should a CRE borrower consider when evaluating a swap?
- How do swaps compare with interest rate caps?
- How are my loan and swap related?
Prepayment/breakage
- What is swap breakage? How do I calculate swap breakage?
- What happens if I sell/refinance my deal when I have a swap?
- My loan term is seven years, but I think I might sell my property in three years. Should I enter into a seven-year swap?
- Why is my swap such a large liability?
- How can I get out of this large swap liability?
- What is a "blend and extend"?
- Can swap breakage be more punitive than a prepayment penalty on a fixed-rate loan?
Documentation
- What is the ISDA and why is it important? Is it negotiable?
- What are the most commonly negotiated ISDA provisions?
- What counterparty protections do I have?
- Can I transfer/assign my swap to a different entity/asset if I pay off the loan early?
LIBOR transition
- How will the LIBOR transition affect my swap?
Swap rates and mechanics
Where can I find swap rates?
Mid-market swap rates can be found on Chatham’s website, and are updated multiple times daily. These should be used for indicative purposes only, not for executing transactions. Swap rates can change materially over the course of day. Please reach out to your Chatham consultant for live swap rates.
In the U.S., it is important to draw a distinction between swap rates on floating-rate loans and swap rates used to price fixed-rate loans. For example, the 1-month Term SOFR swap rate will be relevant when a 1-month Term SOFR loan is being synthetically fixed via a swap, while the SOFR ICE swap rate will be used when pricing a pure fixed-rate loan, like CMBS. In Europe, such distinction is not present in most cases and the same swap rate is often used in floating-rate loans and referenced in fixed-rate loans.
A bank will quote a different swap rate than what you see on our website or a Bloomberg terminal. A swap rate is composed of the mid-market swap rate and a credit charge. The rate that a bank quotes may include this credit charge, and sometimes even the loan spread, representing the rate as an “all-in” coupon. Knowing where mid-market swap rates are when a bank presents you with a quote enables you to better understand the composition of the rate and the spread being charged by the bank. (Back to top)
What should I consider in my term sheet to ensure I get the optimal outcome in my swap execution?
Before signing a term sheet, it is critical to confirm and negotiate the credit charge that the bank is proposing. Many banks will not break down the components of the swap rate in the term sheet. Often, borrowers don’t know to discuss the credit charge at this stage and end up negotiating this fee after they’ve signed a term sheet. This results in less negotiating leverage to secure an improved rate. Borrowers may choose a lender based on a difference in margin of a few basis points, and then give back each basis point (and more) in a swap credit charge they neglected to negotiate upfront. Chatham can advise you during this early term sheet stage and opine on whether the credit charge is in-line with the market.
Another important consideration is whether the bank is applying an interest rate floor on the loan. This prevents the variable interest rate on the loan from falling below a certain threshold, even if the floating rate index (e.g., SOFR, SONIA, EURIBOR) falls. Most loans have floors of at least 0% on the floating-rate index, which can currently be greater than 0%. Early identification of the existence of this floor allows consideration of how it will need to be accommodated within any swap. If a swap is not structured with the floor in mind, the borrower creates the risk of their interest expense increasingif the floating-rate index falls below the floor rate. Borrowers should look out for floors in term sheets, and consider negotiating them lower or out entirely, particularly if they are greater than 0%. More details here.
To ensure flexibility in a hedging strategy, language in the term sheet which allows the choice of hedging alternatives is recommended. (Back to top)
On what types of loans is a swap available?
The availability of swaps on mortgage debt is typically governed by the lending bank and whether they have hedging capability to offer a swap to a borrower. On a typical single purpose entity (SPE)-level term loan, the swap is secured by the underlying asset, often on a pari passubasis to the loan. Consequently, a borrower will need to enter the swap with their lender. Large balance sheet bank lenders have swaps capabilities, as well as an ever-growing list of smaller regional banks. Swaps are less prevalent on debt fund, life insurance company (Life Co), and Agency (Freddie and Fannie) loans. These lenders don’t have swaps desks and/or won’t offer terms which allow a third-party swap provider to secure the swap.
The type of loan is also a factor when considering a swap. Borrowers should be cautious when contemplating a swap on a construction/development loan given the uncertainty of the timing and amount of loan draws. Swap notional profiles must be fixed at inception so if the loan is drawn more slowly than anticipated, the borrower risks paying swap interest on debt that has not yet been drawn. There are ways to mitigate this risk like only hedging a proportion of the forecast drawdowns and potentially combining the swap with an interest rate cap to provide flexibility.
Syndicated loans have their own considerations for swaps. The lending group may involve multiple banks capable of providing swaps, sometimes on just their portion of the loan, but sometimes up to the full loan amount. The borrower may let the lead lending bank “syndicate” out the swap, which may result in sub-optimal pricing, or the borrower may execute the swap with the bank (or combination of banks) which offers the most competitive pricing. (Back to top)
Why am I limited to my lender for an SPE-level swap on mortgage debt?
As swaps involve an exchange of payments between both parties over time, these future obligations create credit risk for both parties. In practice, entering a swap is contingent upon finding a bank willing to underwrite the credit. A borrower is usually required to provide collateral to secure the swap. This is most common when a borrower is an SPE created to hold an asset and associated mortgage debt. Here, the underlying asset will secure the swap by, pari passu to the loan, therefore limiting the borrower to swapping with their lender. This is a key distinction for swaps relative to caps — swaps on mortgage debt must almost always be executed with a lender on the underlying loan.
The exceptions to this are borrowers that can borrow on an unsecured basis. These borrowers, often REITs or open-ended funds, may have multiple lenders that can offer swaps without needing a security interest in the underlying asset. These borrowers may be able to approach a pool of potential counterparties and auction the swap between them, allowing someone other than the lender to provide the swap. (Back to top)
Is there a difference between basis points in credit charge versus basis points in loan spread if they get you to the same all-in coupon?
Yes. While it may be easy to think “basis points are basis points,” basis points in the swap credit charge have much more of an economic impact than basis points in the loan spread in the event of prepayment/termination. The credit charge is a component of the swap rate, which impacts the prepayment expense of the deal. Swap prepayment is calculated by comparing the contract swap rate to the prevailing market swap rate for the remaining swap term. A higher credit charge in the swap rate increases your prepayment cost. The loan spread is not included in the swap rate. Assuming that the loan does not have a spread or yield maintenance provision applicable at the time of prepayment, it does not impact the prepayment profile of the combined loan and swap. As such, it is preferable to shift bank profit from the credit charge to the loan spread to the extent feasible (i.e., accept a higher loan margin for a reduced swap credit spread). (Back to top)
What happens if I have an interest rate floor in my loan? Will it affect my swap?
Swaps should be structured to factor in the underlying loan terms, particularly any interest rate floors on SOFR or other index rates. If a loan has a floor on the index rate, borrowers must decide whether to mirror the loan floor by embedding a floor in the swap. Borrowers can embed a floor in their swap in exchange for paying an incremental premium on top of their swap rate. This ensures a fixed rate on the loan even if the variable rate index falls below the index floor rate. Alternatively, the borrower may structure the swap without the loan floor but will be exposed to higher interest costs if the index variable rate falls below the index floor. For example, if a loan has a 0% SOFR floor, but the related swap does not mirror that floor, if SOFR falls to -0.10%, the borrower will see their interest expense increase by 10 bps (basis points).
In some cases, a borrower may be able to negotiate the floor out of their loan or have the floor waived for any swapped portion of the loan. More often, the borrower must decide between paying a premium in the swap rate to match the loan floor or bear the risk of higher interest expense if rates fall below their loan floor.
Borrowers that have high index floors in their loans should also consider purchasing an interest rate cap in lieu of executing a swap. A cap purchased at the loan floor effectively fixes the coupon of the debt in the same way a swap does on a loan without a floor, but doesn't have the same prepayment risk as a swap. (Back to top)
If I cannot auction my swap, how does Chatham help with pricing on a direct swap with my lender?
Economic and legal terms of swaps can impact investment returns and risks. An advisor will assist a borrower in identifying and negotiating a bank’s credit charge and assist with the execution of the swap at loan closing. Your advisor brings pricing transparency to the transaction when competition cannot provide an incentive for a lender to be transparent. This routinely saves several basis points or more in the overall loan coupon.
An advisor also brings risk analyses, exposure evaluation, and structuring expertise, ensuring the swap is aligned with the underlying loan terms and asset objectives. Your advisor can weigh the costs and benefits of embedding a loan’s index floor into the swap as well as analyzing prepayment risk and potential mitigants. And, your advisor can quantify these exposures leading to a thorough evaluation of hedge structuring strategies.
Finally, the ISDA documents which are used in conjunction with swaps should be reviewed and negotiated to avoid introducing recourse to an otherwise “non-recourse” loan or “backdoor” events of default into the loan. A knowledgeable advisor will be familiar with these documents, negotiate them on behalf of the borrower, and ensure the borrower understands the business implications of the terms to which they agree.
For more details and reasons why Chatham can be a partner, please read here. (Back to top)
What should a CRE borrower consider when evaluating a swap?
Considerations for evaluating a swap include:
- Availability: Because swaps involve an exchange of payments between the borrower and swap provider over time, these future obligations create credit risk for both parties which limit swap availability to borrowers. In most cases, a borrower entity needs to provide some sort of collateral to secure the swap. This is most common when a borrower is an SPE created to hold an asset and the associated mortgage debt. In these cases, the borrower will need to secure the swap with the underlying asset, pari passu to the loan. In practice, this will limit the borrower to swapping with the lender.
- Pricing: Two components — the mid-market rate and the transaction-specific credit charge added to it — make up a swap rate. Borrowers should be aware that the mid-market rate can move significantly between signing a term sheet and the closing of a loan, and, with their advisor, borrowers should identify and negotiate the credit charge before signing a term sheet.
- Legal provisions: A swap transaction will be documented with an ISDA Master and Schedule, industry-standard documentation for interest rate derivatives like swaps. While these documents may be presented to a borrower by a swap provider as boilerplate (or rarely negotiated), both documents should be understood and negotiated. Key provisions include language around termination events that can create cash events prior to loan maturity, language which can allow defaults on unrelated financings to trigger defaults on the swap, and language which can tie non-recourse carve-out loan guarantors to swap obligations.
- Mark-to-market: Over a swap’s life, it may fluctuate between being an asset or a liability to a borrower. This is based on the contracted swap rate relative to the market replacement rate at any given time for the remaining swap term. Swaps will always be liabilities to borrowers on day one equal to the present value of the credit charge and can fluctuate thereafter. Depending on accounting approaches, quarter-over-quarter changes in mark-to-market value may flow through earnings if the swap does not receive appropriate accounting treatment. Investment platforms that use historical cost accounting may find that changes in swap mark-to-market can impact fund returns.
- Prepayment: Although swaps do not have upfront cash costs, they may require a breakage payment if terminated early in conjunction with an asset sale or loan refinance. This penalty will be less than the prepayment penalty on a similarly couponed fixed-rate loan. Prepayment expense cannot be predicted with certainty, but Chatham can provide borrowers with scenario analyses that show potential prepayment costs under different rate environments and hold periods. Swaps may also be structured with open prepay windows to limit potential prepayment costs. (Back to top)
How do swaps compare with interest rate caps?
Interest rate caps are also commonly used to hedge floating-rate loans. Comparing the two:
- Swaps create a fixed-rate profile while caps establish a known worst case for a floating rate, while permitting the borrower to pay the floating rate below the cap “strike.”
- Swaps are most often structured without any upfront payment to the counterparty and often must be done with the associated lender. A cap requires an upfront cash payment but may be purchased from providers other than the lender.
- Swaps may become liabilities over time and require a cash breakage payment if terminated early. Provided that their premium is paid upfront, caps are never liabilities to the purchaser, and, therefore, won’t create the risk of a future cash breakage payment. (Back to top)
How are my loan and swap related?
While a loan and its associated swap are documented as two distinct contracts (the loan being governed by the loan agreement and related documents and the swap by an ISDA and its related documents), there are typically provisions in these documents tying them together. The loan may state that the swap is mandatory, with a default or termination of the swap triggering a default on the loan. Conversely, a default on the loan will typically trigger a default on the swap. Prepayment provisions may also tie the two together, with a payoff of the loan triggering a termination and settlement of the swap. (Back to top)
