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Three Ways to Hedge Real-Estate Bets

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No single vehicle provides total protection.

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Hedging physical real-estate holdings is something we struggle with daily at our company, and in the end, it's easier said than done. There's no one vehicle that can provide protection, so what my firm tries to do is to break down the pieces of our income statement and see where we can minimize risks. Even then, most alternatives tend only to address interest-rate risks.

If you have mortgage rollovers and you're concerned that rates may go higher and impact your cash flow (and even your ability to refinance), there are many products that can buy you protection. Some examples:

  • Forward Locks
    If the loan is maturing within the next 2 years, you could consider "forward locks," i.e. a loan commitment that lasts for 2 years. It involves points, and the underwriting will likely have to be repeated/confirmed near the time of closing, but it removes the rate risk. Given the current environment, the borrower needs to get comfortable that the lender will be around in 2 years.

  • Rate Caps and Swaptions
    There are subtle differences between the 2, but the gist is this: For a premium, one can purchase an option that will pay out if at maturity the option is in the money.

    Let me explain with an example: Let's say the building owner needs to refinance $50 million in 4 years and based on his cash-flow projections, the most he's willing/able to pay is a 9% "all-in" rate on a 10-year fixed-rate loan. That rate will consist of the rate of the 10-year Treasury, plus a risk spread that can vary dramatically based on the credit worthiness of the asset/borrower.

    A "swaption" typically will only protect the Treasury component of the "all-in" rate. So if you buy a swaption struck at 5%, you're now protected dollar-for-dollar if 10-year treasury rate above 5%. The risk spread remains an open question, except that "historically" the spread on a 10-year Treasury swap has captured about 65% of the risk spread of AAA CMBS credits.

    However, in the current environment, that relationship has totally collapsed. The appealing "speculative" aspect of swaptions is that they are "cash settled," i.e. at expiration they'll pay the 10-year present value of however much the swaption is in-the-money. That cash can be used either as a yield subsidy or to reduce the principal amount of the loan, which should make the refinancing easier.

    There are many variations of these instruments, including no-cost collars and straight swaps. In my experience using specialized brokers (such as Chatham Financial) is almost indispensable in guiding one through the process and the significant learning curve involved in these instruments.

  • Loan Extensions
    An often overlooked way to navigate through an uncertain patch is to negotiate the extension of an existing loan with the lender. That's more easily done if the loan hasn't been securitized. Sometimes the lender is just as eager to negotiate such a deal if it means a somewhat better rate and more predictability in performance.
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