Interest Rate Hedging to Reduce Commercial Real Estate Risk

Commercial real estate (CRE) exposure is in the spotlight for banks, investors, and regulators. Real estate data firm Trepp calculates that almost $450 billion of CRE loans will come due this year, with around $270 billion of this total held by banks and thrifts. The coming years see slightly higher volumes, with roughly $488 billion due in 2024, of which $274 billion is held by banks, for example.

The outlook for interest rates remains as opaque as ever, leaving market pundits to debate a bevy of questions:

• How long will the Fed hold its benchmark at current levels (highest since 2007)?
• Will the Fed need to hike further to control inflation which remains near 30-year highs?
• When will the Fed cut rates, how low will they go, and how long will rates remain at those levels?

Adding to the list of factors that the majority of community and regional banks cannot control is the uncertain aftermath of the current banking crisis. Loan-to-deposit ratios have taken center stage in the eyes of regulators and investors alike, and the cost to keep & attract deposits continues to rise. Dare we even mention the debt ceiling impasse and/or the 2024 elections? Alas, it is times like these when it is paramount for banks to control what is within their abilities.

Hedging Can Help – Clarity Is Key

A large population of floating rate loans already have interest rate caps that will need to be renegotiated or replaced to reflect prevailing rates and refreshed valuations. It is no secret that caps in today’s market are trading (costing) multiples of what they were 3, 5, or 7 years ago. Interest rate swaps present an attractive hedging solution with no upfront cost, but the inversion of the curve has shorter-term rates sitting higher than longer-term. And with the lack of liquidity in Term SOFR, many banks are even left pondering what index & spread to utilize for floating rate loans.

A key first step for any bank is to seek clarity about the hedging alternatives that are available and match the proper hedge with their customer’s preferences, liquidity, and risk tolerance. It is an exercise that undoubtedly will require resources of the bank, time being near the top of the list. Having an independent advisor can help reduce the workload and instantly add expertise to be shared across bank stakeholders.

Do Not Repeat Past Mistakes

Whether it be within the fixed income portfolio or fixed rate loans, since 2020 many banks entered troubled waters by extending duration without properly considering the risks. When planning for loans in the coming year, it is important not to fall into the long-term fixed rate loan trap as in the past:

• If rates go higher than expected, deposit costs rise and borrowers hold on to their low fixed rate loans
• If rates go lower than expected, deposit costs decline, but then borrowers look to refinance at more attractive terms
• The ideal scenario would be if held at current levels – an outcome that does not seem likely given today’s market volatility

Consider keeping asset duration short, provide valuable customers with the long-term fixed rates that they deserve (via derivatives), and allow regional bankers to do what they do best – create long-lasting relationships within their communities.

CRE To Be Closely Watched, Ensure Proper Policies Are in Place

Bank regulators have intensified their focus on risk management policies, particularly for regional and community banks, due to recent events such as the failure of Silicon Valley Bank. Recognizing the potential implications of inadequate risk management, regulators have increased scrutiny to ensure the stability of financial institutions. In a recent guidance report, regulators issued a strong warning, stating that banks must have strong board and management oversight, as well as robust risk management processes for their CRE loan portfolios. These measures aim to ensure that banks are well-prepared to navigate the challenges posed by the uncertain economic and interest rate conditions, safeguarding both the institutions and their commercial real estate borrowers.

Interest rate risk management that complements monitoring of loan exposure can be a valuable tool in meeting these expectations for regional banks – and in helping to avert a potential CRE crisis. An experienced derivatives advisor with advanced technology can help to meet this goal through initial policy drafting, robust ongoing exposure assessments, and detailed hedging strategies throughout any/all interest rate cycles.