## Education Corner: Pick a topic to learn more.

### SWAPs and SWAP Spreads

**I. What are Swaps?**

There are many types of swap contracts. In the financial meltdown, the famous swap was the credit default swap (CDS). In that infamous case, AIG agreed to “swap” the credit exposure on mortgage backed securities to those willing to pay them a premium. In other words, AIG said, we will guarantee the credit of those securities, if they default, we will make good on them. The bet went very badly putting AIG into receivership. A swap is a way of transferring risk from one party to another.

There are many types of financial swaps including foreign currencies, corporate bonds, government bonds, and LIBOR based interest based loans. In the case of interest rates used in lending, one party (usually a borrower) swaps its floating rate risk with another party (usually a bank) for a fixed rate risk. In the CMBS context, swap rates are used to price ed rate investor (both called counterparties) each agrees to swap cash flows from their "natural" investment positions. In essence, converting fixed rate investments to floating rate investments and vice versa. The result is a swap contract.

**II. Why are swaps important?**

Swaps enable borrowers and lenders to hedge their interest rate risk to their best advantage and interest rate risk tolerance. It might be a bank whose “book” is too long on its fixed rate loan obligations. Or, perhaps it is a borrower, whose loan is floating rate, who wants their rate to be fixed and not subject to market fluctuations.

**III. How are Swaps priced?**

Interest rate swap pricing is based on the market’s current outlook of short term rates. For example, if a borrower wants to fix the rate on a 6 month loan for $1,000,000 based on a 30 day LIBOR index (the loan reprices every month based on 30 day LIBOR), the swap rate is the rate that equilibrates the expected 30 day LIBOR forward curve to the swapped fixed rate. Huh?

The forward curve is the market’s guess of what 30 day LIBOR will be over the relevant period. See the chart nearby. Let’s say the market is guessing the forward curve on 30 day LIBOR to be .40%, .42%, .44%, .46%, .48%, .50% for the coming 6 months. The expected cash flows are:

Month | 1 | 2 | 3 | 4 | 5 | 6 |
---|---|---|---|---|---|---|

Expected 30 day Libor | 0.40% | 0.42% | 0.44% | 0.46% | 0.48% | 0.50% |

Variable Rate Interest | $ 333.33 | $ 350.00 | $ 366.67 | $ 383.33 | $ 400.00 | $ 416.67 |

Fixed Rate Interest | $ 374.99 | $ 374.99 | $ 374.99 | $ 374.99 | $ 374.99 | $ 374.99 |

Difference | $ (41.65) | $ (24.99) | $ (8.32) | $ 8.35 | $ 25.01 | $ 41.68 |

One counterparty has a fixed rate obligation of $375.00 swaps the other counterparty’s obligation for the floating rate obligation (with a cash flow that we can only guess what it will be). Therefore, the rate which “equilibrates” these two positions is .45%. In this scenario, the swap rate is the average of the floating rates. That usually isn’t the case.

**IV. What is a swap spread vs. a swap rate?**

A swap spread is the interest rate differential between the fixed rates on the float-to-fixed swap contract and the corresponding treasury yield. For example, an investor enters into a float to fix 10-year swap at a fixed rate of 6.20%. If the 10-year treasury yield is 5.10%, the 10-year treasury swap spread is 1.10% or 110 basis points.

**V. What is the Notional Amount**?

The Notional Amount is the theoretical principal amount the swap interest cash flows are based on. The Notional Amount can change. In a construction loan, for example, the notional amount accretes (increases) as the construction loan funds draws through time. Or, the more common scenario is the natural amortization of the loan through time. Amortizations can be tailored in many ways including Straight line, mortgage style, or almost any fashion that is needed.

**VI. Swap Profitability**

If a borrower is entering a swap contract as a counterparty with a bank, the quoted swap rate is the “mid-market” rate that is particular to the exact set of cash flows contemplated. The counterparty, usually the bank, will price a profit spread on top of the mid-market rate. They are required to disclose it. But it is important to negotiate the swap profit spread along with the other loan pricing metrics. The range that we have experienced is from 8 bps to 30 bps.

### Prepayment Penalties

There are many different types of prepayment penalties swirling around two basic concepts. The type of prepayment penalty available is usually dictated by the lender’s funding source. The very cheapest interest rates usually come with the least flexible prepayment terms.

**I. Maintaining the Lender’s yield**

The first concept attempts to make the lender whole on the lost interest payments agreed to in the note. The common clauses are called Make Whole, Yield Maintenance, and Defeasance.

Yield Maintenance ( aka Make Whole): This type of penalty calculates the premium a Lender would need in order to reinvest the funds and get the same rate of return if they are paid off early. The core formula to calculate this type of prepayment penalty is fairly simple (there are variations on the theme). It is the present value of the remaining loan payments (including the balloon at the end) discounted at the treasury yield rate that corresponds to the maturity of the loan (i.e. if you have 69 months left to maturity look at the treasury bond with the closest maturity to 69 months out). Compare the PV with the current principal balance on the loan. The difference is the penalty.

Defeasance: Several years ago a new prepayment form was introduced through CMBS lenders called Defeasance. Prepayment penalty math is similar under the Defeasance methodology as in Yield Maintenance. To defease the loan treasury securities are purchased that **exactly replicate** the cash flow that the loan would have provided to the lender/bond holder over the balance of the loan term. The loan is not actually prepaid to the lender/bond holders at all. Instead, treasuries are provided as collateral in lieu of the real estate with the same cash flow characteristics including principal reduction and interest payments. There is a theoretical situation that the borrower could receive cash from defeasing. If the treasury reinvestment rate exceeds the contract rate of the loan there is a good chance the borrower could be in this enviable position because the bond value of the loan has exceeded the replacement bond value of the treasury securities.

**II.** **Fixed Prepayment**

Many lenders charge a fixed prepayment fee that declines through time. A common one is 5,4,3,2,1. That means at a defined point in the loan the prepayment penalty is 5% of the outstanding principal, reducing to 4% the next year, and thereafter to 1%. In some cases there is a combination of Fixed Prepayment and Yield Maintenance.

If you have a particular prepayment penalty that you need our help with, contact one of our professionals.

### Debt Service Coverage Ratios

**Debt Coverage Ratio(DCR) also known as Debt Service Coverage(DSC):**
One of the basic underwriting tools that lenders use is the DCR. As
lenders continue to be more cash flow driven, and as rates continue to
rise, the DCR becomes more and more important. Simply stated the DCR
measures the cash flow’s ability to cover the debt payments.

1) The ratio is the NOI/ADS. That is, the net operating income divided by the annual debt service. It demonstrates the income stream’s ability to cover the debt obligation. For example, if a property is producing $120,000 of net operating income (income before depreciation and income taxes) and the annual debt service(ADS) is $100,000, the DCR is 1.20 ($120,000/$100,000). The lender concludes that there is a 20% cushion in the cash flow before the payments can no longer be fully met. Lender’s "underwrite" the income side with a variety of things like market vacancy, capital expenditures, market expenses, to reflect what the cash flow would be if they owned the asset. They will often not credit borrower’s operating advantages that are unique to the borrower. For example, if a borrower’s blanket policy is priced at $.15 psf but an individual policy is priced at $.20 the lender will probably use $.20.

2) With rates higher, we have reached the lower tolerance range for lender’s DCR’s. For several years in the lower interest rate environment, DCR’s have hovered in the 1.30 to 1.40 range. Recently they have tumbled to the 1.25 - 1.30 range with the exception of multi-family which can be as low as 1.20. I expect most loan amounts to be DCR constrained while rates are 8% or above.

### Underwriting Metrics

**I. Debt Coverage Ratio**

Also known as Debt Service Coverage(DSC). One of the basic underwriting tools that lenders use is the DCR. As lenders continue to be more cash flow driven, and as rates continue to rise, the DCR becomes more and more important. Simply stated the DCR measures the cash flow’s ability to cover the debt payments.

The ratio is the NOI/ADS. That is, the net operating income divided by the annual debt service. It demonstrates the income stream’s ability to cover the debt obligation. For example, if a property is producing $120,000 of net operating income (income before depreciation and income taxes) and the annual debt service(ADS) is $100,000, the DCR is 1.20 ($120,000/$100,000). The lender concludes that there is a 20% cushion in the cash flow before the payments can no longer be fully met. Lender’s "underwrite" the income side with a variety of things like market vacancy, capital expenditures, market expenses, to reflect what the cash flow would be if they owned the asset. Often a lender will not credit borrower’s operating advantages that are unique to the borrower. For example, if a borrower’s blanket policy is priced at $.15 psf but an individual policy is priced at $.20 the lender will probably use $.20.

The typical range lenders use for DCR is 1.20 – 1.40.

**II. Loan-to-Value (LTV): **

This is the most common metric that lenders use. The ratio of the loan amount divided by the property’s value (loan amount/value). This measures the lender’s cushion from a value point of view, rather than a cash flow point of view measured with the DCR. If the LTV is 70% on a $10,000,000 property, that means the value could erode to $7,000,000 before the collateral value no longer covers the outstanding loan amount.

Value is arrived at in many ways. The most predominant is through a third party appraisal. However, a lender may defer to their own internal estimate of value, or, if the financing is to facilitate an acquisition the lesser of the purchase price or appraised value is used.

Typical LTV’s are 65-75%. Some programs enable the LTV to get as high as 90%.

**III. Loan-to Cost(LTC):**

The Loan-to-Cost ratio measures the loan amount divided by the costs associated to create the asset (loan amount/total costs). All costs are factored in included land, construction costs, interest costs, architectural costs, permits, etc. There is often a discussion about the land value that is credited to total costs. If the land has been owned for several years, had entitlement work completed that creates additional value to the cost basis, the higher value may be counted by many lenders. Recent bank regulations restrict increased land value from being counted in this ratio. On older properties, an effort to estimate replacement cost is often considered.

Typical Loan-to-Cost ratios are 70-85%.

**IV. Debt Yield:**

The Debt Yield measures the assets ability to service debt. It is similar to the DCR, and in fact, is identical given certain assumptions. Debt Yield is the NOI divided by the loan amount ( NOI/loan amount). For example, if a property NOI is $1,000,000 and the loan amount is $8,000,000 the debt yield is equal to .125 or 12.5%. That means the property could sustain an interest only loan bearing an interest rate of 12.5% at a 1 to 1 coverage ratio. Lenders use Debt Yield to measure the assets refinance risk if interest rates rise significantly.

Typical Debt Yield requirements are above 8%.

### Loan Constants

**What is a LOAN CONSTANT and why do you care?**

A Loan Constant is equal to the annual debt service (ADS), comprised of principal and interest, divided by the loan amount (ADS/loan amount). The ratio measures the cash cost, the size of the payment, relative to the debt. An interest only loan’s constant is the interest rate. That same loan, if amortizing, will result in a higher loan constant. For example, a $10,000,000 loan at 5% interest only has a loan constant of $500,000/$10,000,000 = .05 or 5.00%. If that same loan is amortized at 30,25,20, or 15 years the loan constants are 6.44%, 7.01%, 7.92%, 9.48% respectively. Loan constants can be useful to calculate whether the financing is creating positive leverage or not. If you are purchasing a building at a 7 cap ( means that the return is 7% unleveraged), and you put a loan with a loan constant less than 7%, you have positive leverage.

### 30/360 vs. 360 Actual

**What interest rate do you really have? - "30/360" versus "360 actual".**

There are two basic ways to calculate interest. Lifeco’s tend to use the 30/360 method, while CMBS and Bank lenders tend to use 360 Actual.

In the 30/360 methodology it is assumed each month has 30 days and therefore each year 360 days. This is the convention that most financial calculators use (HP-12c and the sort) to calculate the payment schedule that will amortize loans exactly. The stated annual interest rate is divided by twelve to get the monthly interest amount, and then goes through a formula to compute the payment that achieves the given amortization period.

However, on a "360 Actual", (sometimes called Actual 360), the stated annual interest rate is for 360 days. But, the rate actually collected is based on the number of days in the period. The result is that the lender gets 5 additional days of interest (6 on leap years).

**For example, if the stated contract rate is 7.50% on a 30/360 basis, the actual interest charged over the 365 day year is .625% (7.5%/12) per month on the outstanding principal each month or a daily rate of .020833% (7.5%/360) on the outstanding principal for 360 days. If interest is collected on a 360 actual basis then the daily rate is also .020833% on the outstanding principal for 365 days. That relates to an actual rate of 7.604% or 10 bps higher than the stated rate. Payments are usually calculated based on a 30/360 basis for a 360 actual loan. This results in the same payment plan as a 30/360 loan but the loan will not amortize over the stated amortization period because more of the payment is devoted to interest.**