If you’re planning to build and manage a new rental apartment property, it’s not too early to worry about the interest rate on that property’s permanent mortgage, even though the loan won’t close until the community is finished, which might be two or three years away.
Fortunately, large commercial banks are striving to turn their dominance in the world of construction lending into a more robust permanent lending business. Hedges are part of that strategy: These banks are using their trading desks and their connections with Wall Street investors to offer apartment developers the chance to protect themselves from rising rates with hedges that are now more affordable and more popular than ever.
Most of the interest rate of a permanent mortgage is determined by the yield that bond buyers are willing to accept on securities like 10-year Treasury notes and AAA-rated commercial mortgage-backed securities.
The hedge effectively acts as an insurance policy, shielding the developer from the possibility that these bond yields will spike upward and push interest rates higher.
A common type of hedge called a swap can guarantee that in two years, a borrower will be able to close a permanent mortgage with an interest rate based on today’s historically low bond yields. The borrower will have to pay a little extra to secure this low rate, but the price for such a swap has dropped from a 100-basis-point spread over the interest rate, where it stood in the summer of 2004, to just a 20-basis-point spread today, said Jed Guenther, managing director of global rates for Wachovia Bank, NA.
For about twice that price, or an extra cost of 40 basis points, a borrower using a swap can lock in a rate five years in advance. That’s much longer than the rate lock offered by Fannie Mae or Freddie Mac lenders.
A swap also is more flexible than a rate lock, because the swap gives borrowers the chance to negotiate the size of the permanent loan later, when the loan closes, which could mean a larger loan if the projected value of the property has grown.
The typical swap will lock in the interest rate for most of the amount that a developer plans to borrow, but not all of it. A developer planning to spend $24 million to build a community might plan on taking out a $20 million permanent loan in two years. The developer probably will commit to a swap for $18 million, in case the value of the property turns out to be less than predicted upon completion and can only support an $18 million loan, said Mike Slocum, head of real estate financial services for Wachovia.
“You’re taking a guess on the worst case of what the finished, appraised value of a property will be and what loan that it will qualify for,” Slocum said.
If Slocum’s hypothetical property qualifies for a permanent interest rate of 5.8 percent today, a swap could keep the rate of that loan to about 6 percent.
Their flexibility and low prices are making hedges like swaps and caps much more common—and is helping commercial banks tie up a bigger share of the permanent lending business. “Most short-term construction loans are hedged,” said Pete Malicheck, senior vice president for LaSalle Bank.