Hedging Variable Rate Exposure in a Commercial Debt Portfolio Authors Dan Hampton, Senior Vice President, Managing Director and Head of U.S. Commercial Real Estate BMO Harris Bank Timothy Huang, Vice President, Financial Products BMO Capital Markets

Published 8.15.2013 INWH THIS ITE PAPER: • Mechanics of interest rate swaps and caps • Customization options for interest rate derivatives • Examples from the commercial real estate industry resourcecenter.bmoharris.com/whitepapers

Executive Summary

The size and complexity of today’s commercial real estate (CRE) portfolios demand sophisticated and cost- effective ways to both raise capital and manage financial risks. While traditional fixed-rate term loans provide cost certainty, they lack the flexibility required by many borrowers and can be more costly than floating-rate loans. Conversely, a capital structure comprised entirely of floating rate debt may carry an unacceptable level of interest rate risk for borrowers, even though it may provide more flexibility. Fortunately, today’s financial markets provide CRE borrowers with the means to maximize flexibility while managing debt service costs and market risks. In the current lending environment, a growing number of CRE borrowers strategically choose to utilize floating- rate loans paired with interest rate derivatives—an interest rate swap or an interest rate cap—to provide more flexibility and preserve cost certainty. This approach allows borrowers to source the cheapest form of available capital, while still managing interest rate risk inside specific parameters. In this white paper, Dan Hampton, Senior Vice President, Managing Director and Head of US Commercial Real Estate for BMO Harris Bank and Timothy Huang, Vice President, Financial Products, BMO Capital Markets, discuss the mechanics of swaps and caps and examine their application by CRE borrowers to help manage interest rate risk in a variety of situations.

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Tools Used to Manage Interest Rate Risk Example #1: Swaps

Financing commercial real estate has always been Scenario: A borrower finances a or a port- a challenging proposition, but today, borrowers folio of with a floating-rate term loan. have access to more flexible options for managing If left unhedged, the borrower’s cost of funds will portfolio risk than ever before. Tools such as interest increase or decrease as the floating-rate index rises rate swaps and caps can provide borrowers with a or falls during the life of the loan. The diagram be- flexible capital structure with tailored interest rate low illustrates how a swap paired with a floating- protection, providing cost certainty across a range of rate term loan creates fixed-rate financing for a economic environments. borrower. In this arrangement, the borrower makes Before using swaps and caps to manage debt interest payments on its loan, subject to changes in costs, borrowers should first understand how these the variable rate index (in this case, ). In each instruments work. payment period under the swap agreement, the borrower will make or receive a net payment. Interest Rate Swap Mechanics Result: If LIBOR is below the contracted fixed swap An interest rate swap is a standalone contractual rate, the borrower pays the difference between agreement between two parties (in most cases a LIBOR and the swap fixed rate. If LIBOR sets above bank and a borrower) in which the parties agree to the contracted fixed swap rate, the borrower exchange cash flows according to a specific set of receives the difference between LIBOR and the swap calculation parameters, including notional principal fixed rate. When the net payment on the swap is size, floating index, or frequency, over a defined combined with the loan payment, the borrower’s period of time. out-of-pocket interest cost is equal to the fixed rate on the swap plus the loan credit spread. Over the The cash flows exchanged as part of a swap agreement term of the hedge, as LIBOR rises and falls, the bor- combined with those paid on an underlying floating- rower’s cost of funds remains fixed. rate loan—matching terms as appropriate—will result in the same cash flows as if the CRE borrower had

Fixed Swap Rate Borrower Floating Rate LIBOR

Floating Rate LIBOR + Credit Spread Effective All-in Financing Cost = Fixed Swap Rate + Credit Spread Bank Debt

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executed a fixed-rate-loan facility. This creation of could result in a payment to either party. If interest synthetic fixed-rate debt is the most common way CRE rates fall, or fail to climb as forecast, the borrower borrowers use interest rate swaps. will owe a fee upon early termination. Alternatively, if interest rates climb, borrowers could receive a Because a swap is a contractual agreement to pay payment upon an early termination event. a stream of future cash flows, an early termination of this agreement is likely to result in a termination Interest Rate Cap Mechanics payment. However, unlike a fixed-rate loan where An interest rate cap is a contractual agreement an early termination can only result in a payment between two parties wherein one party (the bank) by the borrower, an early termination of a swap agrees to reimburse the other party (the borrower) if interest rates (LIBOR or Prime) rise above a particular threshold (cap strike) during a specific Example #2: Caps period. The borrower pays an upfront premium to the bank for this protection. The amount of this Scenario: The diagram below shows that a bor- premium varies depending on the parameters of rower has a floating-rate term loan and purchases the cap, which may include notional principal size, a cap at a specific strike to set a maximum interest term of protection, or strike level. A cap acts like rate cost. During the term of the loan, the borrower an insurance policy against rising rates, and like an pays floating-rate LIBOR on the loan even if LIBOR insurance policy, will cost more for a higher degree exceeds the strike. of protection (i.e. lower strike level) or a longer

term of protection (i.e., five years versus three Result: For any interest period during the life of years). Caps are commonly used by CRE borrowers the cap where LIBOR exceeds the strike level, the who have an appetite for floating-rate debt but have borrower will receive a payment from the bank to a maximum tolerable cost of funds. compensate them for the increase in LIBOR in excess of the cap strike. This reimbursement effectively sets Provided a borrower has made all required premium a maximum debt-service cost at the cap strike level payments, a cap is an asset owned by the borrower. plus the loan credit spread. Because of this fact, in an early termination event, the value of the cap to the borrower can only be positive (or zero). This means that the borrower will

Cap Premium Borrower Increases in LIBOR above strike

Floating Rate LIBOR + Credit Spread Effective Worst Case All-in Financing Cost = Cap Strike + Credit Spread Bank Debt

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either be able to terminate the cap early without This means that a borrower’s costs remain uncertain further payments or will in fact receive a payment and final project economics are exposed to rising rates if the market value of the cap is greater than zero. during the construction period. F lexible Solutions One tool available to help manage this exposure is a forward starting swap. A forward starting Diversifying a Debt Portfolio swap allows a borrower to enter into a swap agreement Borrowers with a large portfolio of commercial real today with an effective starting date set at some estate often have a target fixed-float mix for their point in the future. Using a forward starting swap in debt capital structures. These borrowers can utilize conjunction with a construction loan allows a borrower swaps and caps to help achieve this mix at either the to lock in the interest rate on the take-out financing individual loan level or across a portfolio of debt. today, rather than wait until construction is completed. This allows a borrower to accurately forecast future For example, through a swap a borrower can fix a interest expense and provide cost certainty. specific percentage of a new lending facility. Alternatively, a borrower could apply the same Customizing Protection Levels approach to a portfolio of loans using one ‘macro’ Many CRE borrowers have a lower tolerance to hedge. This tactic allows a borrower to achieve a rising rates during the early years of a financing, targeted fixed-float mix while retaining the flexibility as cash flow is dedicated to the stabilization of the to choose the most cost-effective funding sources. project. Once stabilization has occurred, borrowers may have the ability to absorb higher interest expense Pre-Hedging Future Term Funding without threatening the viability of the project. Construction loans that convert to term debt at project completion are common CRE financing structures. Purchasing an interest rate cap with a high degree Traditionally, a borrower will not know its cost of funds of protection (i.e. low strike) can address this con- on the term debt until close to project completion. cern. However, as previously discussed, purchasing a

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low-strike interest rate cap can be expensive. protection (i.e. low strike) in the early years of the Fortunately, because interest rate derivatives allow for structure and a lower-degree of protection (i.e. high high degrees of customization, the cap can be strike) in the later years. The cost of a step-up cap will structured to map to a borrower’s risk parameters. generally be lower relative to the cost of a cap with a constant degree of protection at a low strike level. For example, a borrower who expects to have an increased tolerance to rising rates in the later years of a In this way, a borrower can achieve a degree of project could purchase a “step-up-cap.” This variation on protection well-suited to specific needs of the project, the standard interest rate cap carries a high degree of while minimizing the cost of obtaining protection. Moving Forward with Swaps and Caps The preceding examples showcase two of the many applications of swaps and caps by CRE borrowers to manage risk. What makes these tools compelling is their high degree of customization, which allows borrowers to design a hedge that delivers a specific level of protection for any situation or rate environment. However, it is important for borrowers to understand the products, the associated benefits/costs, and the potential risks and rewards in any hedging strategy. Borrowers can look to leverage their financial institutions as a valuable resource for education and to assist in the implementation of a hedging strategy. An excellent resource that borrowers should consider is the knowledge and expertise available from BMO Harris Bank. Through a close partnership between your bank- ing team and individuals from our Financial Products group, we can determine the best instruments and structures to address the specific needs and risk toler- ance for your project or portfolio. Ultimately, borrowers should not hesitate to ask questions to ensure they are comfortable with available products. After becoming familiar with these products, borrowers can use interest rate derivatives to realize short- and long-term risk management benefits and enhance bottom-line results.

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About the Authors

Dan Hampton Dan is a Senior Vice President, Managing Director and Head of US Commercial Real Estate for BMO Harris Bank. He joined Harris N.A. as a result of the First National Bank & Trust of Indiana (FNBT) acquisition in 2007. He is responsible for appropriately aligning people and capital resources to take advantage of opportunities in the market. Prior to joining FNBT, Dan was Managing Director of Indiana Real Estate with Geneva Capital Group, a Chicago- based mortgage banking firm, for eight years. Overall he has 30 years of banking experience, with the past 25 in commercial real estate and commercial banking. Dan is a graduate of the Graduate School of Banking at the University of Wisconsin, the Graduate School of Commercial Lending at the University of Oklahoma, The National School of Real Estate Finance, and the National School of Compliance Management. He also attended the University of Dayton.

For more information from Dan Hampton, read his Insights blog—bmoharris.com/danhampton. To reach Dan Hampton: [email protected] 317.269.1370

Timothy Huang Timothy is a Vice President in the Financial Products Group at BMO Capital Markets in Chicago. He joined the bank as an analyst in 2006 on the Canadian Financial Products team, focusing on interest rate and currency risk management structuring for Canadian corporate clients. In 2008, Timothy transferred to the U.S., where he now provides hedge structuring and marketing services to the bank’s real estate and industrial commercial banking clients.

Timothy holds a Bachelor of Applied Science in Computer Engineering from the University of Toronto and a Master of Administration from the University of Toronto’s Rotman School of Management. To reach Timothy Huang: [email protected] 312.845.4010

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About BMO Harris Bank

BMO Harris Bank’s Commercial Real Estate Group knows that successful real estate firms need a reliable banking partner with an extensive platform of products and services, a solid capital base to ensure the safety of their deposits, and the ability to fund their needs through the economic cycles. The group is comprised of experienced and dedicated banking teams designed to provide creative solutions tailored to each customer’s unique requirements. The Corporate Real Estate team serves the extensive needs of REITs, REOCs, private equity funds, and institutionally sponsored firms throughout the United States. The Middle-Market Real Estate team offers the lo- cal expertise necessary to address the unique demands of private developers and investors transacting on a local, regional, and national basis. Additionally, we have the resources and expertise to provide access to government lending programs, which can offer significant benefits in community development projects.

Deposit and loan products and services provided by BMO Harris Bank N.A. Member FDIC. BMO Harris Bank® is a trade name used by BMO Harris Bank N.A. BMO Harris Bank is part of BMO Financial Group, a North American finan- cial organization with 1,600 branches and approximately $557 billion in assets (as of the first quarter, 2013).

Visit us online at bmoharris.com/commercialbank

This material has been prepared with the assistance of employees of BMO Capital Markets and BMO Harris Bank N.A. (collectively “BMO”) who are involved in sales and marketing efforts. Accordingly, it should be considered to be a solicitation of derivatives business generally and not a research report that reflects the views of disinterested research analysts. Notwithstanding the foregoing, this material should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services (including, without limitation, any commodities, securities, or other financial instruments). We are not soliciting any specific action based on this material. It is for the general information of our clients. It does not constitute a recommendation or a sug- gestion that any investment or strategy referenced herein may be suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this material constitutes investment, legal, accounting, or tax advice, or a representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts and commodity options or any other activity which would cause BMO or any of its affiliates to be con- sidered a commodity trading advisor under the U.S. Commodity Exchange Act. This material is not to be relied upon in substitution for the exercise of indepen- dent judgment. Any recipient of these materials should conduct its own independent analysis of the matters referred to herein. The recipient should seek advice based on its particular circumstances from its own independent financial, tax, legal, accounting, and other professional advisors. These materials are confidential and proprietary to, and may not be reproduced, disseminated, or referred to, in whole or in part, without the prior consent of BMO. Information presented in this material has been obtained or derived from sources believed by BMO to be reliable, but BMO does not guarantee their accu- racy or completeness. BMO assumes no responsibility for verification of the information in these materials, and no representation or warranty is made as to the accuracy or completeness of such information. BMO assumes no obligation to correct or update these materials. These materials do not contain all information that may be required to evaluate any transaction or matter and information may be available to BMO and/or its affiliates that is not reflected herein. “BMO Capital Markets” is a trade name used by the BMO Investment Banking Group, which includes the wholesale arm of Bank of Montreal and its subsidiaries BMO Nesbitt Burns Inc. in Canada, BMO Capital Markets Corp. in the U.S., and BMO Capital Markets Ltd. in the U.K.

BMO Harris Bank N.A. is not a registered swap dealer. As a result, BMO Harris Bank N.A. is not subject to the regulations applicable to registered swap dealers. Borrowers entering into swaps with BMO Harris Bank N.A. will not be covered by the protections afforded by such regulations, including risk disclosure and other informational requirements, margin segregation requirements, and other provisions. “BMO (M-bar rounded symbol) Capital Markets” is a trade-mark of Bank of Montreal, used under license.

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