Another alternative to a vanilla cap is a swap. A swap is a contract to exchange interest rate payments based on an agreed upon notional schedule. The most common is “floating to fixed” where the borrower pays a fixed rate and receives SOFR in return.
Like collars, swaps typically have no upfront cost to borrower, but the downside is locking a swap creates a liability to borrower through the hedge maturity. Borrower gets a known fixed rate but loses the ability to float lower and faces a potential breakage if the loan is repaid early.
Does it matter who my lender is if I want to do a swap?
Yes. Like collars, locking in a swap creates a liability to the borrower (and asset to the bank), resulting in credit exposure that the bank must secure. If the hedge provider is also your lender, the underlying real estate securing the debt will typically be used to secure the hedge as well.
If the lender is not a bank with the ability to offer hedges, the hedge provider would need to be a third party who would likely require cash or other securities to be posted to secure the exposure. Therefore, swaps are uncommon when borrowing from a non-bank lender.
I’ve already read your pieces on caps and collars for construction loans. I’m guessing the future start date and draw schedule is no issue with a swap either?
You nailed it. However, this brings up an important point. Keep in mind that unlike a cap, which just pays YOU when rates are above the strike, interest payments are exchanged under the swap every single period based on a preset notional schedule. If you draw on the loan slower than expected, then you might owe interest under the swap for funds that haven’t been borrowed. This is a risk on the collar floor too.
This isn’t the end of the world, but it is worth understanding the implications. Let’s look at an example of what happens assuming you’ve only drawn $20mm but the hedge notional for the period is $25mm.
If you’re underhedged, the swap payout results in a slight increase or decrease to the net rate (depending on rates at the time) too.
How do borrowers manage the risk of being over hedged then?
There are several common methods one could consider. These include:
What does a swap rate on a construction loan look like today?
Below we’ve outlined a swap rate based on the same forward start and draw schedule. Note, we’ve assumed a 0.15% credit charge for illustrative purposes.
A swap without the forward start and draw schedule has a rate that's quite a bit higher.
A quick note about swaps today – a bank’s derivative sales guy might pitch a 4.05% swap as a “no brainer” since that rate is >1.25% below current floating rates. However, as we found in our previous resource, locking during an inversion has historically been the worst time to do so. That doesn’t mean you should never lock during an inversion; we just encourage considering the alternatives first!
What does the breakage look like if rates fall but I want to prepay early?
Below we’ve outlined a grid showing swap breakages at different points in time and under different rate environments.
Some notes on how to interpret the table above:
Does it matter if my loan has an index floor?
If your loan has a floor, like collars, it could present an issue with a swap. Assume you’re locked at 4.05% and your loan has a 3.00% index floor.
As outlined above, if your loan has a floor and you lock a swap, then you could find yourself paying an even higher rate in the future if SOFR goes below the floor. For this reason, swaps should be carefully considered for loans with an index floor.
It sounds like swapping might not always be the best strategy for hedging the construction period. What if I have a construction to mini-perm loan?
Since forward starting swap rates are lower than their spot staring equivalent, depending on the business plan, swapping may be an interesting option. Borrower could use one kind of hedge during construction/stabilization and forward lock a swap for the mini-perm portion. This likely only makes sense if the plan is to remain in the loan for much of the term though.
For an order of magnitude, below we’ve outlined the 3 year forward 5 year swap rate.
Conclusion
For convenience, we’ve recapped some of the advantages/disadvantages of swaps below.
Advantages of swaps include:
Disadvantages of swaps include:
Given the uncertainty around timing of draws and the ultimate sale/refi, swapping a construction loan can be riskier than using an instrument with more flexibility such as a cap. However, there are some instances where swapping could still make sense and it’s still a tool to consider. Stay tuned for our next resource in a series related to hedging construction loans.
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