Hedging Your Bet:
Interest Rate Hedge Agreements
in Real Estate Financings
Gary A. Goodman
Dentons US LLP
Malcolm K. Montgomery
Shearman & Sterling LLP
Jeffrey H. Koppele
Dentons US LLP
This article is a discussion for the real estate lawyer of the basic considerations of hedging agreements. It raises and addresses several key issues, from both lender and borrower perspectives, including the basic types of hedging agreements, the Dodd-Frank restrictions on eligible contract participants, security and collateral considerations, tax and bankruptcy issues and proper documentation.
HEDGING YOUR BET:
INTEREST RATE HEDGE AGREEMENTS
IN REAL ESTATE FINANCINGS
Gary A. Goodman, Malcolm K. Montgomery and Jeffrey H. Koppele
The expression that “a rising tide lifts all boats” may be easy to disregard in today’s “low tide” of interest rates, but real estate investors who fail to have an appropriate hedge program in place risk being flooded by unanticipated financing costs as the tide inevitably starts to rise. Federal Reserve chair Janet Yellen has said that she expects the Fed to raise its target for short-term interest rates in 2015 should the U.S. economy grow according to expectations[1]. Although many factors influence long-term rates, increases in short-term rates make material increases in long-term rates more likely. Higher long-term rates in turn could expose certain segments of the real estate industry to considerable hardship.
Liberal underwriting standards and a proliferation of lenders have allowed real estate equity investors to finance huge amounts and to refinance at their convenience[2]. In addition, many real estate investment trusts have accumulated substantial debt loads as a result of years of acquisitions, rendering them particularly vulnerable to rising interest rates. Effectively managing interest rate risk will be of vital importance to many participants in the real estate industry in the months ahead.
One of the primary ways in which real estate industry participants can mitigate interest rate risk in financing transactions is through the use of interest rate hedge agreements, which provide both borrowers and lenders with protection against escalating rates. This article provides an overview of interest rate hedge agreements and the selected legal points borrowers and lenders should keep in mind. The article seeks to assist readers in ensuring not only that their hedge agreements successfully mitigate interest rate risk, but also that they are not inadvertently exposed to unforeseen risks in the process.
Basic Types of Hedge Agreements
The three most common types of interest rate hedge agreements are caps, swaps and collars[3].
Under an interest rate cap agreement, the borrower and hedge provider agree to a maximum interest rate, known as the “cap rate”. If the floating interest rate index governing the underlying loan (typically LIBOR) climbs above this maximum interest rate, the hedge provider pays the borrower the difference. In exchange, the borrower pays the hedge provider a one-time fee when the agreement is signed. The result is that the borrower receives protection against any subsequent increase in LIBOR above the cap rate without surrendering the benefits of any subsequent declines in rates.
A swap agreement converts a floating interest rate into a fixed rate. Under a swap agreement, the borrower agrees to pay a fixed rate to the hedge provider, and the hedge provider agrees to pay a floating rate (again, usually LIBOR) to the borrower. If the floating interest rate index on the underlying loan (i.e., LIBOR), rises above this fixed interest rate, the hedge provider pays the borrower the difference. If, however, the floating interest rate index falls below the fixed interest rate, the borrower pays the hedge provider the difference. When the payments between the parties under the hedge agreement are combined with the floating rate index payable on the underlying loan, the net amount paid by the borrower in respect of the floating rate index will always be equal to the fixed interest rate specified in the swap agreement. The borrower is, thus, said to have “swapped” its floating rate obligation for a fixed rate obligation. Note that the borrower would also generally be required to pay the margin (typically a fixed number of basis points) set forth in the loan agreement. Although there is generally no upfront fee associated with a swap, the borrower will be required to make payments to the hedge provider during periods when the floating interest rate is below the agreed upon fixed rate. The structure of an interest rate swap used to hedge a floating rate loan is illustrated in Exhibit 1.
A collar agreement sets both a maximum and minimum interest rate. If the floating interest rate index governing the underlying loan (LIBOR) remains between the minimum and maximum interest rates, the borrower neither makes nor receives any payments under the collar. If, however, the floating interest rate index rises above the maximum interest rate, the hedge provider pays the borrower the difference. Conversely, if the floating interest rate dips below the minimum interest rate, the borrower pays the hedge provider the difference. The borrower is thereby exposed only to a confined range of interest rate fluctuations, i.e., fluctuations between the minimum and maximum rates, and is protected in the event rates rise above the prescribed maximum rate. In addition, although the borrower retains some of the potential benefit associated with declining interest rates, the borrower surrenders the savings that would accrue if rates were to dip below the prescribed minimum rate. In exchange for protection in the high rate scenarios, the borrower may pay the hedge provider an upfront fee, which would typically be lower than the fee required under a cap agreement. In some cases the fee may be waived altogether, if the value of potential payments to the hedge provider in the low rate scenario adequately compensates the hedge provider for its potential costs in the high rate scenario.
International Swaps and Derivatives Association Master Agreement
The International Swaps and Derivatives Association, Inc. (“ISDA”) has published a form of master agreement (the “Master Agreement”) that is intended to function as a comprehensive document reflecting the collective experience of the derivatives industry[4]. The ISDA Master Agreement has been widely accepted and has brought dual benefits of consistency and certainty to the industry[5].
The Master Agreement is made up of three components: the standard form Master Agreement, the schedule to the form (the “Schedule”) and one or more confirmations. The standard form Master Agreement is designed to be used in the form published by ISDA, without variance from transaction to transaction. The Schedule is the instrument used by the parties to select among the various options provided for in the form Master Agreement and to tailor the Master Agreement to the specific legal terms to which the parties to the hedge agreement agree. The Schedule is the document into which the parties incorporate any negotiated points. The confirmation sets forth the economic terms of the hedge transaction and is subject to the legal terms included in the Master Agreement and the Schedule[6]. The parties also may enter into a credit support annex under which a party that is “out of the money” may be obligated to post collateral to the party that is “in the money”.
Key Issues for Real-Estate-Related Hedge Transactions
Adoption of an interest rate hedge agreement can raise many issues. This article focuses on selected key topics.
Eligible Contract Participants
The Commodity Exchange Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)[7], requires that any party to a swap (as defined in the Commodity Exchange Act) be an “eligible contract participant” (“ECP”) unless the swap is entered into through an exchange (referred to as a derivatives contract market) registered with the Commodity Futures Trading Commission. No such exchange has been registered to date, and thus it is currently unlawful for any non-ECP to be a party to a swap or even to act as a guarantor or credit support provider of swap payments.
The Commodity Exchange Act defines the term “swap” quite broadly -- the term includes all three types of hedges described above.
Generally, an entity is an ECP if it has at least $10,000,000 in total assets (among other possible qualifications).
This restriction on non-ECP entities is broadly interpreted to preclude enforcement of a swap if a non-ECP is a direct party to the swap, and enforcement of a guarantee or pledge supporting swap cash flows from a non-ECP guarantor or pledgor. Thus, it is critical for both borrowers and lenders to ensure that each party to the swap, and each credit support provider of swap cash flows, is an ECP at the time the swap or credit support arrangement is entered into.
In many financings, particularly where the swap provider is the same entity as, or is an affiliate of, the lender, the borrower’s obligations to make ongoing swap payments are included in the waterfall provisions in the loan agreement. In such case, the lender should conduct due diligence to determine if any of the borrowers, guarantors or pledgors do not qualify as ECPs. If there is any question regarding an entity’s ECP status, the lender should consider additional measures to ensure that non-ECP entities do not participate as a guarantor or pledgor. For example, each guarantor or pledgor should make a representation that it is an ECP, and this representation should be deemed repeated at any time a swap or guarantee/pledge is entered into[8]. The parties may consider contractually excluding any non-ECP entity from the definition of guarantor or pledgor with respect to swap obligations. The Loan Syndications and Trading Association (“LSTA”) has published model language for such circumstances, which is attached as Exhibit 2. Borrowers may favor that approach. Another approach, more likely to be favored by lenders, would be to require certain borrower entities that qualify as ECPs to provide “keepwell” support to any non-ECP entities, the objective being in effect to convert the non-ECPs into ECPs. The LSTA has published model “keepwell” language for such circumstances as well, which is attached as Exhibit 3[9]. In addition, the lender should make certain that any non-swap guaranty that it obtains in connection with its financing is properly drafted to exclude any guarantee of swap obligations by any non-ECP guarantor[10].
Real Estate Security for Hedge Obligations
Many real estate borrowers are single purpose entities whose credit alone will often be insufficient to support the obligations under an interest rate swap or collar.[11] In such circumstances, the same collateral securing the underlying mortgage loan is often used to collateralize the hedge obligations.[12] This can give rise to unexpected issues.
Many lenders will not agree to share a mortgage or waterfall priority with a third-party hedge provider. Borrowers must, therefore, determine early in the process whether the hedge provider will require a mortgage as security, and if so, whether the lender will agree either to share its mortgage or to take pari passu priority with a mortgage securing the hedge. It may be possible to minimize these issues by obtaining a hedge directly from the underlying mortgage lender, in which case either a single mortgage can be used or the two mortgages can be held by the same or affiliated entities.[13]
Alternatively, it may be possible for the borrower to identify a creditworthy guarantor of the hedge obligations in lieu of providing a mortgage. As noted above, diligence on such guarantors should include confirmation of their ECP-status. If the lender will not permit the hedge provider to be a secured party under the mortgage, another approach is for the hedge provider to enter into the hedge with a creditworthy affiliate of the borrower (whose obligations are not secured by the mortgaged property).
Borrowers with an interest in obtaining the best pricing for their hedge transactions (typically achieved through competitive bidding) should explore the structuring questions described above at the start of the financing transaction rather than deferring them to a stage at which the mortgage lender’s hedge provider affiliate may effectively be the only hedge provider from which a required hedge product can be purchased.
Counterparty Risk
The description above of typical hedge agreements could be read to suggest that the use of these agreements would eliminate the borrower’s interest rate risk. A more accurate view would be that the borrower entering into a hedge agreement has merely exchanged interest rate risk for another risk: counterparty risk. The borrower’s counterparty risk is the risk that the counterparty, i.e., the hedge provider, will fail to perform its obligations under the hedge agreement. If the hedge provider defaults on its obligations, the borrower generally is required under the loan documents to obtain a replacement interest rate hedge agreement. In the case of an interest rate cap agreement, however, the borrower will have paid the hedge provider at closing. In this circumstance, not only would the borrower have to pay a second time for a hedge agreement that it had already purchased, but the replacement cost may far exceed the cost for the original hedge if interest rates have gone up in the interim[14].
A borrower may minimize its counterparty risk by negotiating certain additional terms into the hedge agreement. One way of minimizing counterparty risk is to require the hedge provider to post margin in an amount equal to the value of the hedge agreement; the concept is that, upon a default by the original hedge provider, the borrower would be able to use the collateral it is holding to purchase a new hedge agreement to cover the remaining term of the original hedge agreement. Another approach would be to obligate the hedge provider to replace itself, i.e., cause a new hedge provider to enter into a hedge agreement with the borrower covering the remaining term of the original hedge. A third approach would be to require the hedge provider to supply a guaranty from a creditworthy entity, often an affiliate of the hedge provider. In some cases the parties negotiate that these remedies would be required only if the hedge provider’s credit ratings drop below specified thresholds. These provisions generally protect the lender as well as the borrower, because they minimize the risk that the borrower will have to incur an additional expense to acquire a replacement hedge agreement. Some lenders require borrowers to include these provisions in their interest rate hedge agreements.
Definite Obligation
Under the laws of some states, in order to be recorded and enforced a mortgage must state a specific principal amount or definite obligation. Under a swap agreement, however, the obligations of the borrower are by their nature indefinite. There is no principal obligation at issue and, depending on whether the agreement is “in the money” or “out of the money”, there may or may not be amounts payable by the borrower to the hedge provider under the agreement.
If the hedge provider and the mortgage lender are the same entity, this problem can often be addressed by characterizing any swap payments as additional interest in the documents governing the loan and using a single mortgage to secure both the swap obligations and the obligations under the other loan documents. Alternatively, if the hedge provider is a separate but affiliated legal entity, the mortgage lender may agree in the loan documents to advance, as so-called “obligatory advances”, any payments due from the borrower to the hedge provider under the swap agreement. Such obligatory advances are then secured by the mortgage and, because of the obligatory nature of the advances, the priority of the lien securing them can in some states relate back to the date the mortgage is first recorded.[15]
If the hedge provider is a third party unaffiliated with the mortgage lender, neither of the above approaches to the indefinite mortgage problem may be available. Therefore, borrowers should consult with local counsel to identify any definite obligation requirements during the early stages of deal structuring.
Mortgage Tax
In states that impose a mortgage recordation or similar tax, two separate taxes will be imposed if the mortgage lender and hedge provider are granted separate mortgages. If the lender and hedge provider are the same entity, the second layer of mortgage tax can often be avoided by using a single mortgage and characterizing any payment obligations under the hedge agreement as additional interest under the loan documents. Such a characterization will not be an available option if the hedge is secured with a separate mortgage. Consulting with appropriate local counsel early can ensure the structure avoids unnecessary taxes, particularly in jurisdictions such as New York City, where the mortgage recording tax is 2.8% of the principal amount of the obligations secured.