This short paper looks at how interest rate hedging products have been used historically in the real estate market, how this behaviour has changed over time and concludes with a framework that borrowers and banks should consider when entering into interest rate hedging to protect real estate debt liabilities. This research was funded and commissioned by the IPF Research Programme 2011–2015.
The FCA’s Interest Rate Hedging Products review has highlighted to many people how unaligned the banks and their borrowers can be with regard to executing suitable interest rate hedging.
In addition, there have been several articles and comments in the press with regard to how the mark-to-market overhang from legacy interest rate derivatives has prevented the flow of transactions in the property market, with many participants instead having to extend their funding rather than sell their property assets in order to allow the mark-to-market of their interest rate hedging to ‘burn-off’.
One of the outcomes of the financial crisis that started in 2007 is that derivatives have been much maligned, being described as ‘weapons of mass destruction’, despite being highly beneficial financial tools that, if used correctly, can be extremely useful to borrowers to manage their financial risk.
This paper examines the use of interest rate derivatives in the real estate market in the UK. It considers those issues that have characterised the interest rate hedging strategies adopted and aims to provide a better understanding of the relative advantages and disadvantages of differing strategies. Whilst the focus is on real estate, many of the themes arising out of this paper are easily transferable to other sectors.
Before entering into a hedging arrangement, the borrower should always understand the purpose of the hedging. In very broad terms, there are two types of hedge: a fair value hedge and a cash flow hedge. A fair value hedge is one that seeks to protect against changes in the value of an asset or liability that are due to changes in a particular variable, for example using a property derivative to hedge the capital value of a well-diversified portfolio of property assets. A cash flow hedge is a hedge that protects the variability in the cash flows of a specific asset or liability due to changes in a particular variable, for example, the cash flow liability from the interest payable on floating rate debt.
Interest rate hedging, as predominantly used in real estate transactions, is designed to be a cash flow hedge of the interest payable on floating rate debt. If used appropriately, there is a range of interest rate hedging instruments that allows users to effectively manage their interest rate risk.