Negative interest rates are driving up the costs of real estate lending, property chiefs have warned. The problem is that no one really knows what’s going on. Part of this is down to the complexity of everything, but it’s also because the legal shenanigans surrounding lending haven’t caught up with monetary policy.

Potential mismatches between loans and associated interest rate hedging threaten to raise costs – which is rather counter-intuitive given that rates are falling. For the variety of reasons I’ll explain, borrowers are now being advised to audit loan agreements to avoid being caught out.

There has been widespread criticism of the European Central Bank (ECB) reducing interest rates. Moody’s warned last month of “potentially adverse effects on final stability” in Sweden. Similar reports around a housing bubble in Denmark have been echoed by Larry Fink, chief executive of BlackRock.

At a Commercial Real Estate Finance Council (CREFC) Europe seminar in London last week, experts warned that commercial property investors face new considerations and costs on new deals, and potential problems in historic deals. This is because specific provision needs to be made, and the associated cost paid, to include an interest rate floor in an interest rate swap. While that has become a sensible precaution in the current interest environment, it certainly wasn’t routine a few years ago.

With the potential for rates to decline further (see note 2 below), this will be a concern to many.

The problem of hedging interest rates

In effect, and at a cost, interest rate swaps allow a borrower to convert a flexible floating-rate loan into a fixed-rate liability that its rental income is expected to cover.

While loan agreements can include a safety net so that floating interest rates stop at zero (to prevent lenders having to pay borrowers), many older interest rate hedging derivatives don’t do that; a typical interest rate swap would not cater for this unless an interest floor is explicitly included in the contract.

“Derivatives play a crucial role in financing by allowing borrowers and lenders to hedge risk, for instance related to interest rates. The problem is that derivatives may not be set up to deal properly with negative rates,” said Adam Dann, partner at Berwin Leighton Paisner, a law firm.

Rules set down by the International Swaps and Derivatives Association (ISDA), which is responsible for standardised derivatives agreements, govern how swaps are structured. A “plain vanilla” interest rate swap would not (and should not) include an interest rate floor, but the position is different when a swap is used to hedge interest rate risk in a loan that does include such a floor. (See the example in note 2 for an illustration of the problem that can arise).

“A mismatch occurs when borrowers wish to hedge the loan with an embedded floor using a conventional interest rate swap,” said Nadim Mezher, a director in global banking and markets at HSBC.

“This is because the floating leg of an interest rate swap does not include a zero percent LIBOR floor, thus exposing the borrower to an increase in the combined financing cost should LIBOR turn negative, in the absence of a zero percent floor in the hedge,” he added.

While including an interest rate floor in an interest rate swap is straightforward, pricing it can be challenging. Mark Battistoni, managing director at Chatham Financial, the world’s largest independent interest rate and foreign exchange risk management advisor, believes parts of the derivatives markets have had a very hard time adapting to negative rates.

“Models need to be revised or scrapped in favour of new ones – in particular for interest rate options such as caps and floors,” he said. “The pace of change varies by banks, so even now, the product capabilities and price differential between mainstream banks for some hedging products is shockingly wide.”

The problem for loan agreements

In the lending context, the problem posed by negative rates is clear: if the reference rate in a floating rate loan falls below zero, the lender won’t receive the full margin for which it bargained. And if the reference rate moves far enough into negative territory, the lender could, in theory, end up having to pay the borrower interest.

The obvious solution is for the loan agreement to include a zero floor for the interest rate payable, so that the lender never has to pay interest to the borrower. The Loan Markets Association (LMA), which maintains standard form documentation for the loan syndication market, is understood to have recommended the inclusion of such a provision. But not all transactions are documented using LMA documentation, and older deals may not include a zero floor.

“In some sectors – like the leveraged corporate space which is dominated by institutional debt providers – LIBOR floors have been prevalent at levels above zero for a number of years,” said HSBC’s Nadim Mezher.

“Now that negative interest rates have become a reality in some currencies and a possibility in others, many lenders are requiring zero percent LIBOR floors on loans. This is required to protect lenders’ loan margins as some central banks have begun charging banks for excess reserves in markets where policy rates are negative, while banks in general have yet to pass on this cost to their retail and corporate clients,” added Mezher.

“There are numerous unintended consequences arising from negative rates,” Peter Cosmetatos, CREFC Europe’s chief executive said. “One issue, historically as well as for new deals, is ensuring that both loan agreements and related hedging arrangements all work and fit together as they should. Addressing risks in that area is likely to carry a cost.”

He added: “More broadly, our sense is that, while most lenders remain disciplined and responsible, the monetary policy environment is creating perverse drivers and unintended risks in cyclical real estate markets. Crucially, real estate investment has a key role to play in economic recovery across the world. And while only five central banks currently have negative rates, their jurisdictions account for almost a quarter of global GDP, and the international nature of real estate capital flows means that knock-on effects will impact in many markets.”

1. ECB’s warning in minutes of council meeting

Minutes from the ECB’s governing council meeting on 7 April hinted that rates could declines further:

“Concerns were raised about possible undesirable side effects that could arise from moving further into negative territory, particularly in combination with fast-growing excess liquidity. A further cut in the deposit facility rate could unduly increase the pressure on banks’ profitability…

“Lowering the rate further into negative territory was seen as an effective tool for providing additional monetary easing, which also reinforced the impact of the other monetary policy measures.”

2. Example of swap contract

Assume a Swiss borrower has entered into a floating rate loan of 50 basis points over three-month Swiss Franc LIBOR, that it intends to service using rental income. In order to ensure that its ability to service the loan will not be affected by rising interest rates, the Swiss borrower has purchased a swap. Under that swap, the Swiss borrower pays a fixed rate of 2% to the swap dealer. In return, the swap dealer pays three-month Swiss Franc LIBOR plus a spread of 50 basis points – matching the Swiss borrower’s payment obligations under its loan. Taking the loan and the swap together, the Swiss borrower now has, in effect, a fixed rate exposure of 2% (as three month Swiss Franc LIBOR plus 0.5% payments under the loan and receipts under the swap cancel each other out). If the reference rate increases, the borrower’s overall financing cost remains 2%.

However, if the reference rate drops to negative 0.75%, the borrower still has to pay 2% under the fixed leg of the swap, but rather than receiving 0.5% under the floating leg, it will have to pay an additional 0.25%. That might not matter if the loan being hedged was also now paying the borrower 0.25% – but that is very unlikely to be the case. If the loan is written in a way that places a floor under the reference rate to ensure the lender always receives its spread, the borrower will still be paying 0.5% under the loan. Arrangements intended to ensure that the borrower’s net overall financing cost was 2% will have resulted in the borrower having to pay 2.75%.

3. The global picture on negative rates

1.     Bank of Japan: BOJ announced rates at -0.1% for banks parking additional reserves on the 29th of January 2016. This was to encourage bank to bank lending and discourage keeping reserves tied up.

1.     European Central Bank: As well as cutting it’s main rate to zero in March the ECB cut deposit rates by 0.1 percentage point on March 10th to -0.4% to hold bank’s cash overnight.

1.     Sweden, Riksbank: Came in to effect in February 2015, set at -0.1% and has cut steadily ever since- cutting their central base rate to -0.35%.

1.     Denmark, Nationalbanken (central bank): In July 2012 the Danish Central Bank cut its deposit rate to -0.2% (making it the first country to ever truly introduce a negative rate; Sweden had cut rates in 2009 but very little cash was deposited at a negative rate so it had very little market impact).

2.     Switzerland, Swiss National Bank: Have a long-term policy of low rates (employing a negative deposit rate of -0.75% since January 2015) to drive inflation and push down currency value- as of late march 2016 key deposit rates were held steady at -0.75% (they have said they generally want to avoid hitting a -1% rate).