|
Accounting
and Taxes | "Accounting
and Tax" Archive
Curtail
the risk of reeling rates
ABOUT
THE AUTHOR |
 Kurt
Taves is
a Certified Public Accountant, a tax
partner in the Hampton Roads office of Cherry,
Bekaert & Holland LLP and the
director of the firm's Real Estate & Construction
Industry Group. He can be reached at ktaves@cbh.com.
|
|
| |
by Kurt
Taves
for Virginia Business
January 2007
Knowing whether interest rates will skyrocket or plunge
is an ongoing challenge for most real estate investors.
The stakes are high, and more often than not, bargain
basement rates mean profitability for some otherwise
unattractive properties. In contrast, rates gone wild
can plunge even the most profitable bottom line into
dark financial depths. How can you mitigate these two
extremes? Try an interest rate swap, which can curtail
the risk of these reeling rates.
Hedging on rates
If you absolutely require a fixed rate loan for your
real estate investment but can't seem to get one, don't
worry. Locking in a lower fixed rate is possible, even
when your bank offers only a variable rate loan.
Using an interest rate swap, you can actually trade
your variable rate off to another party. It's only a
paper arrangement, but you promise to pay the other party
a fixed interest rate calculated on your mortgage amount.
In exchange, you receive a variable rate payment based
on the mortgage's principal.
This agreement doesn't kick in unless the interest rates
change. So if the rates stay constant, no one pays. If
they decrease, you pay the difference between the fixed
and variable rates. If the rates increase, the trading
partner pays you the difference.
In the past, these swaps received a bad rap from those
who consider this method a mild form of gambling. Conversely,
those who favor swaps point out that many wheat farmers
rely on commodity futures contracts to reduce price fluctuation
risks. Interest rate swaps provide the same type of security
to real estate investors who believe that, to turn a
profit, they need a fixed rate.
THE
SECRET LANGUAGE
OF SWAPS |
An
interest rate swap is a contract by which one party
(who has committed to paying a fixed rate) and
the counter-party (who has committed to paying
a variable rate) trade interest rates on pre-determined,
future debt. The principal (or debt) itself isn't
exchanged. If you're serious about using this arrangement,
you must familiarize yourself with the terminology.
Here's a breakdown of the lingo:
• Counterparties -
The parties involved in a swap.
• Swap
rate - The difference between current
U.S. Treasury rates and the fixed rate of interest
quoted in a trade.
• Tenor -
A swap's duration.
• Fixed
and floating legs - The two sides of a
swap, with the fixed leg being the party with
the fixed rate loan and the floating leg being
the variable-rate counter-party.
• Interest
rate cap - A purchase limit on the amount
an interest rate is allowed to rise that protects
investors particularly sensitive to spiraling
rates.
• Interest
rate floor - The opposite of an interest
rate cap, with the limit on how long - rather
than how high - an interest rate can go.
• Collar -
This is the result of the combination of an interest
rate cap with an interest rate floor. To finance
the cap, an investor sells the floor. |
When swapping makes sense
Interest rate swaps provide an excellent planning tool
for investors who want to focus on their core businesses
rather than financial market speculation. Swaps provide
such investors with a viable vehicle to reduce interest
rate risk and lock in attractive long-term rates.
Real estate investors can convert existing variable
rate mortgages into fixed rate financing without the
time, trouble and expense of negotiating a loan. Some
swap agreements also allow mortgage holders to shorten
or lengthen the required payment time without having
to recognize a gain or loss.
Swaps are especially attractive to investors who, because
of the nature of their investments, need a guarantee
that no matter how much interest rates fluctuate, neither
payments - nor investment yields - will change during
the arrangement.
When one party has access to lower fixed rates and the
other party has access to lower floating rates, a swap
can be mutually beneficial. Some real estate investors
use these deals to lock in favorable interest rates while
waiting for a loan to close or even before they've found
an attractive investment. Sometimes you may be best off
on the variable rate side of a swap. For example, some
investors are able to repay fixed rate financing more
easily by converting the financing from a fixed to a
variable rate loan.
To determine whether an interest rate swap is right
for you, consider how susceptible your investments are
to adverse rate changes. Would very high or very low
rates kill your portfolio? Then you may want to lock
yourself into the middle.
If you need protection against
future interest rate increases, you may also consider
a "swaption." In
this arrangement, you buy a cap on future swap rates
by paying a one-time premium. If market swap rates rise
above the swaption rates, you can exercise your option
and still swap under the agreed-on terms. If market swap
rates decline and stay low, the option will expire worthless
and you can conduct a swap at the lower market rates.
Laying your plans
Controlling interest rate risk is one of the toughest
and potentially most expensive challenges facing most
real estate investors today. Some of the factors affecting
variable interest rates include - but aren't limited
to - global markets, financial regulation and their
own inherent volatility. Predicting future interest
rates with any degree of certainty is next to impossible.
Yet it is precisely this prediction - of future interest
rates - that so often affects both the price and long-term
profitability of a real estate investment.
If you need stable interest rates and think a swap might
be your solution, check with us. We'll help you evaluate
the benefits and dangers and determine what's best for
your investment needs.
-------------------------------------------
Kurt Taves is a Certified Public
Accountant, a tax partner in the Hampton Roads office
of Cherry, Bekaert & Holland
LLP, and director of the Firm's Real Estate & Construction
Industry Group. He can be reached at ktaves@cbh.com.
|
