August 15, 2022

If you’ve been sleeping through 2022, here’s what you missed: Actor Will Smith was banned from the Oscars; the LA Rams proved that their new stadium might be worth the money they shelled out for it; and Manchester City managed to choke yet again in the Champions League. Oh, and interest rates shot up.

The 10-year Treasury rate jumped from 1.51% at the close of 2021 to 3.29% by mid-June 2022. The last time it was that high was back in 2011 when the Netherlands were Baseball World Cup champions … and the Baseball World Cup still existed. The consensus among most economists is that rates will continue to climb throughout the year, as the Federal Reserve maintains its policy of hiking short term interest rates in an attempt to curb inflation.

But while rising rates are typically viewed in a negative light, it’s possible to capitalize on the opportunities of the situation — and mitigate the impact on your practice — by using a few key strategies. The optimal course of action will vary from group to group depending how much debt you have, how it’s structured, and how much risk you’re comfortable with taking.

The Upside: Groups With Swaps and Conduit Loans

Your time in the spotlight has come! When rates go up, groups that have existing swaps or insurance/conduit loans in place are in luck. Depending on your situation, you’re either a “Winner” or a “Big Winner.”

The “Winners” are those who had swaps or conduit loans that were heavily “out of the money,” meaning that these groups would have had to pay their lenders a hefty amount to prepay their loans. These borrowers were effectively blocked from refinancing or making other moves that may have been desirable, such as further leveraging the real estate investment to enable more affordable buy-ins for partners.

The recent rise in interest rates, however, means that many of these groups are no longer saddled with this contingent liability, and it may be an opportune time to revisit changes that could positively impact the sustainability of the group’s investment.

The “Big Winners” are those groups that entered swaps in the last two to three years; those swaps now have a substantial positive value, meaning that the bank will pay the doctors to terminate that swap early. There are several ways that groups can take advantage of these positive swaps, including:

  1. Terminating the interest rate swap to provide cash-out to partners.
  2. Improving cash flow by blending the positive value into a new swap and re-amortizing the debt.
  3. Using the positive swap value to pay down principal on the loan.

If you have an interest rate swap, it is worth finding out what the mark-to-market (also known as termination value or swap unwind) is on that swap so the group can understand its available options. This value can be provided by CMAC or any independent swap advisor. Banks can also provide the information but may skew the unwind value in their own favor.

The Downside: Groups With New Real Estate Projects

We certainly understand the sleepless nights caused by the rising interest rate environment, and the impact it’s likely to have on new real estate projects. Those concerns are not without merit, as interest rates will play a significant role in a group’s return on investment. For those groups that are willing to assume a little more risk, however, a floating rate option could be an attractive proposition.

According to JP Conklin, Founder & President of Pensford, there has yet to be a time in history where a 10-year fixed swap rate has outperformed the comparable floating rate option. Assuming we don’t break from the historical norm, a floating option could save borrowers a significant amount of interest expense over the term of the loan.

It’s also worth noting that there’s nothing precluding a group from utilizing an interest rate swap to fix the rate in the future. In fact, this could be a very effective strategy employed by groups to take some of the risk off the table later, when interest rates may be more favorable.

Economists expect rates to continue rising in the short term, but most also agree that a recession could be right around the corner — along with the expected decrease in rates that comes along with it.

This expectation is reflected in current rate projections, which have short term interest rates priced higher than long term rates, otherwise known as an inverted yield curve. So, for those groups that are willing to take an educated gamble, floating rate options could provide an attractive avenue in the current higher rate environment.

The SPREAD, the whole SPREAD, and nothing but the SPREAD!

While there’s nothing a borrower can do to control market interest rates, or  “the cost of funds,” the profit a bank adds to that cost (the SPREAD) is completely negotiable. The importance is the same in either a floating rate loan or with a loan fixed via an interest rate swap. Every basis point (.01%) added to the spread can have a significant impact on the returns of a borrower’s investment.  

For example, a single 0.01% to the rate of a $20MM loan is valued in the range of $16,000. Therefore, just 25 bps (0.25%) in additional spread results in a present value cost to the borrower of roughly $400,000. Banks also add a profit to the cost of a swap, and generally do not disclose that additional spread to the borrower. For this reason, it is wise to work with an independent swap advisor, such as Pensford, whenever entering into a swap.

It’s said “everyone wins in a rising tide” — and while the same may not be true for rising rates, there are still plenty of opportunities for savvy practices to capitalize on the advantages of this unique real estate market, while mitigating the downside. If you’d like help exploring the options that may be available to your group, reach out to solutions@cmacpartners.com.