Restructuring interest rate derivatives for European publicly listed real estate investors
Summary
Interest rates in Europe have been on a downward pathway since the end of 2018, accelerated recently by the monetary stimulus launched to deal with the economic fallout from global lockdown.
Many commercial real estate investors are exploring ways to restructure their hedging in order to:
- Take advantage of the lower rates now available in the market
- Reduce overall funding costs in the short term when rental income is under pressure
- Improve EPRA KPIs, such as EPRA earnings and EPRA earnings per share
How is this achieved?
When looking to lower interest expense, investors can restructure their interest rate swaps through re-couponing.
Re-couponing settles the mark-to-market of the existing instrument (in cash) and reduces the fixed swap rate to the lower market rate. This improved rate is then paid until the original maturity of the swap, essentially locking in the interest expense saving to maturity. The cost of such a strategy is approximately equal to that of the saving, save for transaction charges.
This will cause a cash event and the hedge counterparty will typically need to receive the settlement of the mark-to-market within two business days of the restructure.
What is the impact on key performance indicators (KPIs)?
For European publicly listed real estate investors who report KPIs in accordance with EPRA (European Public Real Estate Association) guidelines, changes in the fair value of financial instruments such as derivatives are excluded from EPRA earnings.
This is because the objective of EPRA earnings is to provide an indication of the underlying income performance generated from the leasing and management of the property portfolio in a way which enables comparison with other similar businesses. Including the fair value of hedging instruments in EPRA earnings would not provide consistent comparability of the core property business across companies.
Therefore, fair value of derivatives, such as interest rate swaps used to hedge the interest rate risk, would not affect EPRA earnings. Furthermore, the restructure of financial instruments with a maturity date ending beyond the current reporting period would also be excluded from EPRA earnings.
Interest payments on derivatives such as interest rate swaps, however, are recorded in EPRA earnings. This means that the benefit of the restructure, in the form of lower ongoing interest expense, is recorded in EPRA earnings whilst the cost of the restructure is excluded1.
The resulting lower interest expense could improve headroom on interest-linked financial covenants such as ICR and DSCR and improve other financial KPIs such as EPRA earnings per share.
Risks and considerations
Eligibility: Re-couponing the swap rate should improve the lender’s credit position and should be a straightforward process. The swaps should not already be designated as cash flow hedges.
Liquidity: Re-couponing out of the money swaps will require paying the existing swap liability to the bank, making this unsuitable for borrowers who may be facing immediate liquidity constraints.
Market risk: The cost of the swap breakage will vary depending on prevailing market conditions at the time of restructure.
Example
In 2019, a borrower with a £10 million loan maturing June 2023 priced at LIBOR + 2.00% and swapped to fixed at 1.50% pays the swap breakage cost of £395,000 and re-coupons the swap rate at 0.19%, bringing the all-in coupon down to 2.19% for the remaining term.
We assume that the borrower is not applying hedge accounting and the swap was re-couponed on the last day of the previous financial year for £395,000. The mark-to-market of the re-couponed swap on the last day of the current financial year is a liability of £50,000.
The swap breakage cost represents a cash crystallisation of derivative mark-to-market movements that impact IFRS earnings but which are excluded from EPRA earnings. Whilst, the reduction in interest payments post-restructure impacts both IFRS earnings and EPRA earnings, it results in an improvement in EPRA earnings per share.
Summary and next steps
Re-couponing swaps allows EPRA-reporting CRE investors to immediately reduce interest expense and see improved EPRA earnings. Any borrower undertaking this restructure should ensure to market benchmark the economics and trading costs, and fully understand the risks and benefits of the exercise.
Please feel free to reach out to your Chatham representative if you would like to further evaluate the availability and suitability of such a transaction.
1Calculating EPRA earnings is potentially more complex in situations in which the company is applying hedge accounting to their underlying IFRS numbers.
Disclaimers
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
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