Interest Rate Swaps – Fixed for Floating Rate Exposure
An interest rate swap is a financial contract in which two parties agree to exchange distinct cashflows for a given period of time. A common swap structure in commercial real estate is the “plain vanilla” swap, where the borrower pays a fix rate and receives SOFR in return from the swap provider.
Example:
The borrower acquired a commercial property with a floating-rate loan of $10,000,000 on a 5-year term. The variable rate is tied to SOFR + 2.50%. The borrower entered into a swap agreement with a bank to “swap” their floating payments for fixed payments. The borrower now pays a fixed rate to the swap provider, while continuing to make the regular floating-rate payments to the original lender. The SOFR cashflows that the borrower receives on the swap net out the SOFR component of the loan, leaving the borrower with a net fixed rate + spread.
The $10,000,000 loan at SOFR + 2.50%, these loan payments go directly to the lender. Through the swap agreement, the borrower pays a fixed rate of 4.10%, while receiving SOFR from the swap provider.
If SOFR = 4.35%. The loan payment to the lender is 6.85% (4.35% + 2.50%). The borrower pays the swap provider the fixed rate of 4.10%. The borrower receives from the swap provider 4.35% (SOFR). The net result is the borrower pays 6.60% (4.10% + 2.50%), which is 25 bps lower than the original loan.
Conclusion: Borrowers use interest rate swaps to exchange their floating rate exposure for fixed rate, hedging against rising rates. Note that the all-in interest rate the borrower pays includes a credit charge from the bank that provides the swap. This transaction specific mark-up is designed to compensate the bank for the credit risk they take in providing the swap and to provide that department a return. This mark-up will differ from deal-to-deal (swap rate + credit charge + loan spread). There is also prepayment risk associated with interest rate swaps, a breakage payment may be required if the borrower exits early.
