Sizing Up the Impact of Derivatives Regulation on the European Property Sector Panning Back — How Requirements Will Change Risk Management & Financing Strategies While the impact of these requirements on risk management and financing strategies remains unclear, we can say that the cost of managing risk will increase and, as a result, will alter hedging behaviors. The increased cost will be driven by, for FCs, the need to post collateral when transacting at the fund level; and, for NFCs, increased capital requirements and funding costs applicable to their dealer counterparties — costs which will be passed on in the form of higher transaction prices. For FCs, the key question will be how a margin requirement will affect hedging strategies, particularly as it relates to fund level currency hedging. A real estate fund’s high cost of capital generally makes the potential tying up of cash highly dilutive to investment returns, likely causing deep consideration as to the trade-offs between risk management and returns. To optimize these competing tensions, funds might alter the ways in which they manage their risk. For example, they might shorten the term of their hedges, or purchase options rather than enter into forward contracts in order to set a known worst-case for the amount of cash that would need to be deployed to hedging activities. For NFCs, the key question will be whether the increase in transaction cost is sufficiently material to cause a change in hedge strategy or structure. Potential responses to increases in hedging cost may include increasingly relying on fixed rate debt where possible, increasing the use of options, and shortening the duration of hedges. Opportunities for Changing the Law An important question for real estate companies sour about the impact of financial regulatory reform on their risk management programs might reasonably be whether the types of hedging activities they engage in might one day be exempted from key requirements. While policy makers are not presently looking for opportunities to sharpen the focus of their derivatives reforms, it is likely that they will one day consider making discrete changes where those changes will not adversely impact their overarching goals of systemic risk mitigation or transparency. CRE Finance World Summer 2014 40 Real estate hedging activity is one area in which such changes might reasonably be considered, given the industry’s use of derivatives as a risk mitigation tool and its reliance on physical assets to secure derivatives trades, rather than the liquid assets often required under central clearing and margin requirements. One obvious starting place for a discussion along these lines would be to exempt swaps provided in connection with the origination of loans from the definition of swap. Such an approach would acknowledge that the impact on the banking system from the failure of a real estate entity would be no greater if that entity defaulted on a fixed rate loan or a swapped floating rate loan. And such an approach would recognize that, because market participants can readily compare the pricing of a swapped floating rate loan with the pricing on a fixed rate loan, such an exemption would have no material bearing on policy makers’ transparency objectives. Summary Even while derivatives regulatory reforms take their long-march toward completion, past and future regulatory requirements and increasing anticipation regarding enforcement activities dictate increased attention to compliance from real estate finance teams. And even while focusing on the administrative actions necessary to stay in compliance, it will remain important for real estate investors to keep an eye toward the strategic implications of these regulatory changes on their approach to risk management. Phong Dinh and Luke Zubrod advise companies on risk management and derivatives regulations at global risk management advisor Chatham Financial, an advisor to more than 1,200 end users of derivatives.
CRE Finance World, Summer 2014
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