Managing Interest Rate and Currency Risk in the World of Real Estate
Real estate developers, investors and funds must be aware of a multitude of risks that could impact their businesses. Inflation, interest rates and currency volatility can have a significant impact on the real estate sector. Hedging these market risks could lock in rates on interest and foreign exchange and eliminate the variability in these unpredictable times. Understanding the current market landscape and the hedging products available to real estate clients is the first step in proactively addressing these increasing market risks.
For the first time since 2018, the Bank of Canada (BoC) increased the policy interest rate by 25bps on March 2nd, 2022. Borrowers have enjoyed the benefits of the pandemic-induced emergency level low interest rates for two years; however this hike is the first signal of a rapid changing interest rate environment in Canada. With inflation at its highest levels in over 35 years, the Scotiabank official forecast is calling for eight more hikes the BoC in 2022 and 2023, taking the overnight rate to 2.50% by December 2023. Markets are already pricing in another 25-50bps increase at the next BoC rate announcement on April 13th.
The Bank of Canada is also closely monitoring global market events and will use the projected impacts as an input in their decision-making process. With the unprovoked invasion of Ukraine by Russia and the sharp rise in prices for oil and other commodities, inflation is expected to increase across the globe. As the economy continues to expand and inflationary pressures remain high, interest rates are expected to further increase in the coming months.
The volatility in interest rate and currency markets is significant, and the risks that real estate investors must consider should be top of mind. Taking a proactive approach to understanding and potentially hedging these risks could be critical for businesses before market conditions change even further for the worse.
If you wait, it may be too late.
“The best hedgers are proactive and do so at the onset of the loan. We help them forecast their cash flows over the coming years, budget for their principal and interest rate payments, and then find ways to stabilize their borrowing costs to align with their budgets and forecasts.” Brittany Owens, Director, Commercial Derivative Products Group.
Many borrowers assume they only have two choices - a fixed or floating rate - but capital markets instruments (i.e., interest rate swaps) can be used to combine those features to achieve greater flexibility. “The risks are real”, notes Owens. “Imagine a client who has a $5 million loan. If interest rates rise 2.25 per cent, that’s roughly $112,500 per year in added interest expense, which can eat away at your bottom line.”
That’s especially pertinent today as our economists forecast that the Bank of Canada will continue to hike rates six more times in 2022 and two more in 2023. If you consider that a typical rate increase is 25 basis points, and that eight more increases are forecasted for this coming rate hiking cycle, a borrower with floating rate debt could see a further 200-basis point increase soon.
Unfortunately, many ‘sit on the fence’ even when they hear about Bank of Canada rate hikes. “It’s been almost four years since the last interest rate hiking cycle, so many people have become accustomed to low floating rates. They think they can ride out the current rates until they start to move. However, if you wait, it could end up costing a lot more for a fixed rate in the future,” says Owens.
Take guesswork out of rate decisions.
Scotiabank’s Derivative Products Group thoroughly explains the benefits of using capital markets tools, such as interest rate swaps, forwards and options customized to a client’s loan. Among them, these hedging products provide flexibility not available through conventional fixed rate loans, including portability among other loans or lenders and preferential ‘break costs’ if the borrower chooses to pay down or revise their lending strategy later.
Many clients assume that such hedging is only available for large corporations and some clients have only heard about the infamous, high-risk derivative products used by Wall Street investors. However, such infamous derivatives are very different from those widely used to manage interest rate and FX risks.
Foreign Exchange or “FX” risks can add another important consideration in making real estate investing decisions. Shifting currency rates that truly hurt your bottom line.
While our fluctuating dollar impacts every company doing business outside of Canada, few businesses have a plan to manage their foreign exchange FX risk. Fortunately, Scotiabank makes hedging strategies accessible to Real Estate clients, to manage their foreign exchange exposure while doing business in distant markets.
“As we’ve seen throughout history, currency rates can (and do) move significantly. Not being hedged can result in the value of a firm’s foreign revenue being reduced, or the costs of overseas expenses abruptly increasing. Our products help to provide more certainty in these currency risks, reducing volatility of profit margins.” Alexandra Schroder, Associate Director, Commercial Foreign Exchange & Derivative Products Group
From peak to trough, USDCAD moved 18 cents in 2020, followed by about 10 cents in 2021. For a firm with USD expenses, that could be a big enough move to put their margins underwater if they did not have a FX hedging program in place. Despite this reality, and the fact that so many Canadian companies do business across borders, only half of companies with currency exposure have a defined hedging strategy.
Noting that two-thirds of companies rely on economic forecasts to try to ‘time’ currency purchases, Schroder explains that, instead, a company should have a strategic discussion with a foreign exchange specialist. These specialists help clients by providing forecasts and assisting them with putting together budgets to analyze the impact of currency rates on specific project profitability.
Real estate companies are unique in the sense that their projects are usually longer in term than many other industries, making the potential impact of FX moves even more significant. Often FX conversations occur at the start of a project, moving funds across the border to begin construction. This is then followed by medium and long-term hedges for the cash inflow when the project is slow, or when future payments are needed for various stages of construction. “We understand timelines for project completion are fluid, and so is our product offering” notes Schroder. Our group works with clients to suggest ways to extend tenors or change expiry dates to meet a client’s needs.
With the world being so interconnected, it’s rare to find a client with zero currency risk exposure. Since every project is different specialists work with clients directly to understand their timelines and goals, to which they suggest tailor-made hedging solutions or a range of products that could meet their needs. Scotiabank’s offerings range from full-service strategy and sales support by dedicated currency experts, to 24-hour, self-directed access to real-time trading and market rates in 30 major currencies through ScotiaRed, the Bank’s dynamic online trading platform.
Owens and Schroder add that they find it very rewarding to demystify capital markets products for clients: “When we meet with individual clients, or host FX and Interest Rate hedging seminars across Canada, we break it down so that everything is digestible for busy leaders who are focused on their own business priorities.”
“There’s an FX or Interest Rate solution for everyone, whether it’s an outperformance strategy or a more vanilla structure with zero market risk and total peace of mind; ultimately it depends on your goals and comfort level.” Owens points out that Scotiabank’s Derivative Products and FX Specialists also travel extensively to meet face-to-face with clients.
“We accompany our client on the whole journey and keep them top of mind throughout the length of their hedge, so we can consider new ways to structure their hedges for the latest rate and currency environment. During the pandemic, we worked extensively with clients to restructure their hedges to best meet their needs in unprecedented times.”
So glad they ‘fixed’ when they did.
Anyone who still doubts the value of hedging their interest rate or currency risk should talk to a company that has either learned the hard way, or the right way.
Owens recalls a client who was grateful for Scotiabank’s proactive advice when they were planning to increase an existing $5 million loan. “The client wanted to wait a few months, until they completed the final draw and could put a hedge on the larger loan they were arranging. However, we reminded them that rates could shift drastically in just a few months. Fortunately, they decided to lock in the bulk of their existing debt at that point. Today, they are so glad they did because their final debt draw was delayed, and interest rates rose abruptly. Additionally, they can restructure the existing swap to add in the incremental debt when the final draw takes place, and this will keep their hedging structure very simple.”
Owens marvels at how the market has evolved in recent years: “In the past, these financial tools were exclusively for multi-national corporations, and now, thanks to competitive innovation, technology and the growing sophistication of business operators, a company with approximately $5 million in debt can benefit from these same products.”