The cost of breaking swaps contracts taken out by real estate investors who borrowed in Euros at the peak of the property market in 2006/07 has increased substantially, according to an analysis by global real estate advisor, CBRE.
Created as a hedging instrument, swaps were intended to protect real estate loans with high LTV ratios, which typically have low interest rate cover, against interest rate rises. However, as the financial crisis drove interest rates down to unprecedentedly low levels, these instruments have become increasing burdens on investors wishing to sell their properties, affecting willingness to sell and, in the case of potential distressed sales, the recovery of value to lenders.
Currently, the cost of breaking a 20 year swap contract taken out at the peak of the property market in the Eurozone (Q4 2007) has jumped to 31% of the total value of the original loan as at the end of Q1 2012. Weak economic data and the ongoing Eurozone sovereign debt crisis are continuing to push down medium to long-term Euro interest rates, pointing to a continuance of this trend.
The interest rate on a 20 year swap taken out in December 2007 would have been about 4.9%. As at the end of Q1 2012, the equivalent fixed interest rate for the remaining 15.75 years of that swap contract was about 2.7%. In order to break that contract, the borrower would need to pay an up-front lump sum equivalent to the present value of that additional interest, which explains the 31% break cost for such a swap.
The picture in the UK is not quite as extreme, as UK swap rates have been slowly increasing over the last few months, mitigating the break cost somewhat. The UK property market also peaked about a year before that in the Eurozone, meaning that Q4 2006 is the most relevant period to look at.
However, UK investors have experienced additional difficulties as, at the peak of the market, many borrowers took out longer swap contracts than were absolutely necessary, due to the fact that long-term interest rates were then lower than short-term interest rates. Looking at the example below, we can see that the longer the swap term, the greater the associated breakage cost.
Philip Cropper, Managing Director, Real Estate Finance, CBRE, commented: “The cost of breaking swap contracts associated with property loans taken out at, or close to, the peak of the market is proving a material factor in the work out strategies of lenders considering distressed asset sales. As we can see from our analysis, at the extreme, the cost of the breaking a 20 year Euro denominated swap taken out in December 2007 could wipe a significant amount from the sellers’ return. In a challenging market, this is frustrating the recovery process as lenders try to deleverage their balance sheets. It also penalises other investors seeking to dispose of performing assets.
“The irony of this phenomenon is that swaps were intended as an instrument to protect investors from the risk associated with rising interest rates. However, at the peak of the market no-one anticipated that we would enter such prolonged low interest rate environment.”
“In working out property loans, banks face considerations relating to provisioning and the current and future prospects for both the underlying assets and the borrower. The scale of the potential costs of breaking swaps, and a bank’s own capital adequacy requirements, add further significant complications to the process, which we believe are having a major impact on decision making. ’The key to working ones way through these situations is understanding the interaction of all the moving parts.’’