A.CRE

Interest Rate Swap

An interest rate swap is a financial contract in which two parties agree to exchange one stream of interest payments for another, over a set period. Typically, this involves swapping fixed-rate loan payments for variable-rate payments, or vice versa. This can be used by real estate investors to manage interest rate risks, particularly in scenarios where they might have a loan with a variable interest rate but prefer the predictability of fixed payments.

Modeling a swap from a real estate financial modeling perspective is similar to modeling a fixed rate mortgage, with the possible inclusion of a) a rate buydown where the borrower pays a premium to secure a rate swap that is below par and b) a swap term that may (or may not) be co-terminous with the mortgage loan term.

Putting “Interest Rate Swap” in Context

Scenario Overview

Meadow Lane Capital, a real estate investment firm specializing in value-add projects, has acquired Garden View Apartments, a 150-unit garden-style apartment complex in northern New Jersey. The property was purchased for $25 million, with a planned $3.5 million renovation budget to upgrade unit interiors, modernize amenities, and enhance landscaping. The acquisition was financed with a $17.5 million variable-rate loan, representing a 70% Loan-to-Value (LTV), with the renovation funded through $3.5 million in equity contributions.
The loan is tied to SOFR (Secured Overnight Financing Rate) with a 2.5% margin, resulting in an initial rate of 5.0% (SOFR at 2.5% + 2.5%). The loan term is five years, with interest-only payments during the initial two-year renovation phase.

Interest Rate Risk Mitigation

To achieve greater predictability in its debt service costs, Meadow Lane Capital entered into an interest rate swap. Through the swap agreement, Meadow Lane Capital exchanges its variable-rate interest payments for fixed-rate payments with a strike rate of 5.25% for the next five years. This effectively converts the variable-rate loan into a fixed-rate loan, protecting the project from potential increases in SOFR over the swap term.
The swap cost includes a one-time rate buydown premium of $150,000, enabling the firm to lock in a slightly below-market fixed rate. The swap term is co-terminous with the loan, ensuring consistent protection throughout the project’s lifecycle.

How the Interest Rate Swap Works

Under the swap agreement:

  • Meadow Lane Capital pays a fixed interest rate of 5.25% to the swap counterparty (a financial institution).
  • The swap counterparty pays Meadow Lane Capital an amount equivalent to the variable SOFR + 2.5% margin.

Effectively, Meadow Lane Capital continues making its loan payments to the lender at the original variable rate, but the swap neutralizes the variability by reimbursing the excess cost above 5.25%.

Example Scenarios:

  • If SOFR rises to 4.0%, the loan’s variable rate becomes 6.5% (SOFR + 2.5%). Meadow Lane Capital receives 1.25% (6.5% – 5.25%) from the swap counterparty, neutralizing the increase.
  • If SOFR remains at 2.5%, no payments are made to or received from the counterparty, and the fixed swap rate (5.25%) governs the loan payments.

Financial Impact

By entering into the interest rate swap, Meadow Lane Capital gains predictability in its debt service costs, enabling better financial planning for the renovation and stabilization period. The fixed rate of 5.25% provides cost certainty and shields the project from rate volatility.
Projected Annual Debt Service:

  • Loan Balance: $17.5 million
  • With Swap (fixed rate of 5.25%): Annual debt service = $918,750
  • Without Swap (SOFR at 4.0%): Annual debt service = $1,137,500
  • Annual Savings: $218,750 in a high-rate scenario

While the swap’s upfront cost of $150,000 adds to the project’s expenses, the potential savings and risk mitigation justify the investment.

Trade-offs and Risks

The swap provides predictability but comes with trade-offs:

  • If SOFR remains below 2.75%, Meadow Lane Capital’s fixed payments exceed the variable rate loan payments, resulting in additional cost.
  • The one-time buydown premium increases the project’s upfront expenses, though it enhances the project’s financial stability.
  • Swap agreements are binding contracts, so terminating the swap early may incur penalties or costs.

Additional Considerations

  • Loan Term Alignment: The swap is co-terminous with the loan, ensuring consistent protection throughout the entire loan period.
  • Compliance with Covenants: A fixed-rate payment structure helps Meadow Lane Capital maintain compliance with lender-required debt service coverage ratios (DSCR).
  • Market Trends: The fixed rate of 5.25% reflects an expectation of rising SOFR rates, balancing risk mitigation and cost efficiency.

Conclusion

The interest rate swap is a valuable tool in Meadow Lane Capital’s financial strategy for Garden View Apartments. By converting the variable-rate loan into a fixed-rate payment structure, the firm mitigates interest rate risk, ensuring stable debt service costs throughout the project’s renovation and stabilization phase.

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