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High Costs of Interest Rate Hedging Plagues Real Estate Companies

Industry: Construction; Real Estate
Current: Company Performance

Prices on some contracts increased at least 10-fold in October 2022 over that in the corresponding period in 2021, placing real estate companies at a severe financial disadvantage in protecting their variable debt from interest rate increases
Real estate companies that rely on floating rate financing are often required by banks and other lenders to protect themselves with so-called interest-rate limits
Some businesses seek alternatives to the caps as the US Federal Reserve continues its campaign of interest rate increases, such as replacing the caps with fixed-rate debt or hedging their variable debt

Soaring Costs of Real Estate Companies

Real estate companies are facing increasing costs to protect their variable debt against jumps in interest rates, with prices on some contracts jumping at least 10-fold in October 2022 over that in October 2021.

Banks and other lenders often require real estate firms relying on floating rate debt to hedge their exposure with so-called interest-rate caps. The caps are derivative contracts sold by the lender, in which companies receive a payment when an interest-rate benchmark—for example, the Secured Overnight Financing Rate/SOFR—exceeds a certain level. Companies must buy these caps after they secure new debt and risk defaulting if they violate that covenant.

The caps, which are also used in other industries, shield companies from sharp increases in rate benchmarks such as SOFR or the London interbank offered rate, which support trillions of dollars of financial contracts, including corporate loans, mortgages, and interest-rate derivatives. They limit borrowers’ interest costs and assure lenders that a risk potentially affecting their client's ability to service their debt is mitigated. The real estate market value increased significantly in 2022 over that in 2021, according to GlobalData.

As the US Federal Reserve continues its campaign of interest rate increases, some companies are looking for alternatives to the caps, for example by taking out fixed-rate debt instead or hedging their variable debt. Real-estate companies are struggling with cost increases for labor and building materials and slowing demand. There has been a significant increase in the mortgage rate in the US in October 2022 over that in the previous months, according to GlobalData.

Companies tend to buy and sell caps in one transaction with the same bank to avoid credit exposure. Banks usually include the planned sale along with the purchase in one contract, allowing companies to pay one net price and less than they otherwise would have paid to buy the new cap.