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3.5 INTEREST RATE RISK HEDGING

In structured real estate loans, cash flows from the project (e.g. rental payments and/or amounts received from the sale of properties financed) are used in order to repay the loan instalments. It is therefore necessary to strike a balance between incoming cash payments (rent and/or sales) and outlays (instalments plus costs) for the real estate project financed. An increase in the instalment following a rise in the floating rate could lead to a potential default on the deal. For this reason, if a fixed interest rate is not chosen, it will be necessary to hedge against the interest rate risk. The various forms of hedging[1] which are considered are principally Caps, Collars, and Swaps.

3.5.1 Interest Rate Cap

An Interest Rate Cap, or simply a Cap, is an instrument for hedging against the risk of an interest rate rise; the borrower will continue to pay the floating rate whilst he will also acquire (generally from a bank, though not necessary the lender) for a fee the right to apply an Interest Rate Cap. If the interest rate exceeds the agreed Cap, a third party defined as the counterparty will pay the bank the difference between the Interest Rate Cap and the actual interest rate at the time each instalment falls due.[2]

It is clear that an Interest Rate Cap will be chosen in order to ensure that debt servicing[3] remains at sustainable levels, and hence that operating cash flows (e.g. rental payments) and financial covenants (e.g. DSCR and ICR) will be calculated on the basis of the level of Cap chosen.

The lower the Interest Rate Cap, the higher the fee the borrower will be required to pay to the counterparty (and vice versa).

  • [1] See Hull (2012) and Fabozzi et al. (2007).
  • [2] For a numeric example see paragraph 4.4.3 Loan with Interest Rate Caps.
  • [3] The whole amount due in the period, as sum of interest and principal.
 
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