Why hire an advisor for a lender-required swap?

Commercial real estate (CRE) borrowers often encounter interest rate swaps in conjunction with debt financings. For many bank lenders, a swap, offered with a floating-rate loan, is an efficient way to provide fixed-rate debt. Often, these swaps must be secured by the underlying property being financed and, as a result, swaps on mortgage debt are commonly executed directly with the lender or members of the lending group (if it is a syndicated loan). As many aspects of swap economic and legal terms may be negotiable with the lender and can impact investment returns, many CRE investors choose to engage an advisor to assist in structuring and negotiating swaps, even if they are done directly with a single lender. The following are some of the key benefits of utilizing an advisor on a lender-required swap.

Why use an advisor?

Pricing transparency

A borrower’s total swap rate generally consists of the two components below. The borrower’s synthetic all-in fixed-rate will be the sum of these components plus the loan spread.

• Mid-market rate: A market driven rate based on current market expectations for SOFR resets over the term of the swap. This fluctuates over time with market movements but should largely be an objective and verifiable number.
• Credit charge: Negotiated, deal-specific charge based on the perceived credit quality of the borrower entity and the profit expectations of the lender’s swaps desk (distinct from the loan returns). This may be thought of as an additional component of the loan spread, albeit one paid to the lender’s swap desk, not their lending group.

An advisor can assist a borrower in breaking their lender’s component pricing into these parts and provide transparency at closing, including:

• Assisting the borrower in negotiating the bank’s credit charge: Agreeing on a swap credit charge (expressed in basis points) upfront and as a part of the overall loan terms will enable both parties to know that the final rate a borrower pays is what was negotiated even as the underlying mid-market rate fluctuates over time.
• Assisting the borrower in executing the swap at loan closing: At the time of swap execution/loan closing, the negotiated credit charge is added to the then prevailing mid-market rate and the swap rate (and all-in loan coupon) is locked in. While many large banks are required by law to disclose their mid-market rate, many smaller banks are not, and some banks will include a small mid-to-offer spread that may range from a few tenths of a basis point to 1-2 basis points.

An advisor can routinely save the borrower at least several basis points in the overall fixed loan rate, and, in many cases, quite a bit more.

Economic risk analysis and structuring

While many borrowers rightly think of swaps and the underlying mortgage debt as part of the same overall transaction, and in most cases the swap can not exist without the underlying loan, they are typically documented as two separate, but interrelated contracts. If structured without consideration for the underlying loan terms or the underlying asset plan, a swap may result in unintended consequences over the life of the investment. An advisor identifies and analyzes these risks to help borrowers weigh the costs and benefits of potential structures. Examples include:

• Loan floors: Most floating-rate CRE loans now include a floor on SOFR (often 0%), which prevents the interest rate on the loan from falling below a certain threshold even if SOFR falls. If a swap on such a loan is not structured with the floor in mind, the borrower creates the risk of their interest expense increasing if SOFR falls below the floor rate.
• Prepayment risk: Swaps do not have upfront costs, but they can be future liabilities and result in breakage costs if terminated early. The amount of this swap breakage is the present value difference between the borrower’s contracted swap rate and the prevailing mid-market swap rate for the remaining swap term (the replacement rate). If the borrower’s rate is above the replacement rate, the swap will be a liability. Conversely, if the borrower’s rate is below the replacement rate, the swap will be an asset.

Documentation review and negotiation

Swaps are documented separately from a loan agreement using an industry standard set of documents known as an ISDA. While often presented to borrowers by their lender as a boilerplate document, parts of the document may be negotiated to be more or less favorable to the borrower, particularly with respect to default and termination events and ties to other investments the owners of the borrower may have. While some outside counsel that represent borrowers have expertise in this area, many others do not. An advisor will review and coordinate other swap-related documentation such as:

• Pre-trade Dodd-Frank/EMIR compliance forms with the bank
• Trade documentation (i.e., swap confirmation) to ensure the bank has accurately summarized the trade terms after execution

Why use Chatham?

Pricing transparency

Chatham advises on $4 billion+ of hedged notional every day, giving us significant visibility into market credit charges for different lenders and financing profiles. We leverage this market presence to reduce the borrower’s all-in synthetically fixed loan coupon and to quantify the dollar value of the credit charge being paid to the lender’s swaps desk.

During execution, Chatham validates the mid-market rate to which the credit charge is being added and advises on the appropriateness of any mid-to-offer spread based on then current market conditions.

Economic risk analysis and structuring

Chatham works with borrowers to quantify potential breakage costs in consideration of the plans for the underlying asset and provides what-if scenarios to help quantify possible outcomes. This often includes evaluating embedding options in swaps that allow borrowers to prepay the underlying debt without any potential swap breakage.

Documentation review and negotiation

Chatham reviews and negotiates over 2,000+ ISDAs annually, giving us unmatched insight into which provisions are negotiable with different lenders and what may be appropriate for different sponsors and borrowing situations, allowing a borrower to quickly get to market terms independent of or in conjunction with a borrower’s outside counsel.

Derivatives experts with unmatched perspective

Chatham brings transparency to each of these components and leverages its expertise and market awareness to ensure that the borrower gets best possible terms and has no surprises over the term of the swap. Chatham is the market leading advisor for interest rate swaps, executing over 6,000 swaps every year. And with over 700 employees globally, 3,500 clients, and $1 trillion transaction volume annually, Chatham helps real estate investors maximize their value in the capital markets, every day.