Sizing Up the Impact of Derivatives Regulation on the European Property Sector How Real Estate Companies Use Derivatives Real estate companies have long relied on derivatives to manage interest rate and, in some cases, currency risk. Given the importance of debt in partially funding most real estate purchases, interest expense is often the largest expense a real estate company faces. It is only natural then that real estate companies and their lenders seek to control what can be a volatile and potentially devastating variable in the overall financial performance of their investments. The manifestation of interest rate risk in real estate markets arises, in part, from the various types of lenders in the market. Insurance companies, for example, lend on a fixed rate basis given the longterm nature of their liabilities. Banks, meanwhile, typically lend on a floating rate basis to match the variable rate funding on which they often rely. CMBS investors lend on both fixed and floating rate bases. Real estate investors often prize the predictability of fixed rate debt, but also value the ability to tap various pools of liquidity. Derivatives are the tools that permit everyone to meet their objectives – lenders get what they want – fixed or floating – while borrowers can get the predictable interest expense they often desire. In recent decades, many real estate investors, having built globalized investment platforms, have also had to employ currency risk management tools. A UK-based real estate fund investing in Europe, for example, uses foreign currency forward contracts or options to protect against depreciation in the Euro vs. the British Pound. Such depreciation could cut into a real estate fund’s equity investment and accumulated profits, reducing or even wiping out a fund’s investment returns. Currency hedges have thus become essential in ensuring cross-border real estate investors’ returns are based on their real estate acumen rather than their prescience in predicting currency movements. Regulatory Impact on Various Real Estate Players Rather than serving as a tool for accumulating vast amounts of risk exposure, as was the case with AIG, derivatives use by real estate companies for hedging has been useful in promoting balance sheet health. Indeed, policymakers attempted to acknowledge this reality by creating exemptions for nonfinancial companies from many of the salient economic features of the law, including the CRE Finance World Summer 2014 38 central clearing requirement. But rather than tying the availability of the exemption to a particular entity’s contribution to systemic risk or its purpose in using derivatives, the end-user exemption is applied based on a company’s form of organization. Most nonfinancial corporations can rely on the exemption, as can the Special Purpose Vehicles (SPVs) in which many real estate investments are held. Alternative investment funds, including real estate funds, cannot rely on the exemption. Many REITs remain uncertain about the availability of the exemption, which may depend on a REIT’s country of origin. For many companies – especially real estate funds – the dividing line between exempt and non-exempt is drawn right through the organizational chart. The interest rate hedging done within the SPVs is exempt, while the foreign currency hedging done at the fund level is subject to the economically intensive provisions of the law, including clearing and margin. And, importantly, while some real estate companies have escaped many of those economically intensive portions of the law, all real estate companies are subject to the law’s administrative requirements. Current State of Play — Risk Mitigation Requirements and Regulatory Enforcement It is the law’s administrative requirements that have taken center stage so far, with various aspects of the law becoming effective in succession. In March and September 2013, companies became subject to EMIR’s risk mitigation requirements, requiring changes to policies and procedures to address, among other things, timeliness of trade confirmations and a new concept called “portfolio reconciliation.” These requirements are aimed at mitigating risk between the counterparties, in the first instance by prescribing a shortened timeframe within which trade confirmations need to be executed (currently between 1 and 4 business days following trade execution). Secondly, portfolio reconciliation requires companies to compare key transaction terms and derivatives valuations, identifying material differences and engaging with bank counterparties to resolve any disputes. For many companies, the tip of the portfolio reconciliation spear was negotiating and entering into agreements with bank counterparties on how portfolio reconciliation would be done. Once agreed, real estate companies need to carry out the procedures set forth in those agreements either annually or quarterly, depending on whether the real estate company is a financial counterparty (FC) or nonfinancial counterparty (NFC).
CRE Finance World, Summer 2014
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