Every client situation has its own characteristics, challenges, and goals. We tailor our client’s plan to fit.
We invite you to see what we mean by taking a look at the five sample CIRM client projects described here. In each case, the “Benefits to Borrower” is shown as savings. You can also think of it as improved cash flow.
The CIRM’s ideal, often honored more in the breach than the observance, is to help our clients during negotiations with prospective lenders. In this recent case, we exploit that rare opportunity to the fullest — to our client’s financial advantage:
For this loan, the lender requires the borrower to purchase an interest-rate cap of 5% LIBOR running to the loan’s initial maturity in three years. The client is inclined to accept. After all, 5% seems like a reasonable cost of doing business… and it’s below budget.
One other fact, little noticed by the client: the yield curve is flat.
Our detailed analysis presented during negotiations persuades the lending bank to:
All payments averted—$358,000—drop straight to the bottom line.
It appears that only by spending $154,000 on an interest rate cap can the borrower ensure, to the satisfaction of both lender and equity partner, that it will meet the budgeted interest expense.
The CIRM assists the borrower in subsequent negotiations. Our recommendations show persuasively that by implementing rate protection in stages over a defined period we eliminate the need for a cap and provide upside for considerable savings on interest expense.
The keystone is a participating swap, structured by The CIRM, that fixes the interest rate on a majority of debt and caps the remaining debt.
This structure not only keeps payments $250,000 below budget during the construction period. Additionally, it puts our client in the enviable position of benefiting regardless of whether LIBOR rises or falls.
Out-of-pocket expense: $18,000—versus the lender’s proposed $154,000 cap.
Lesson: The most effective structures are invariably tailored to project characteristics, rely on the most up-to-date information, and proceed through a series of informed interest rate decisions over the term of the loan.
The Fed has just raised interest rates for the first time in years. LIBOR has risen to 3.5%. Our client wants to buy an interest-rate cap for three years at 7.0% to cover the remaining term of its loan, and has budgeted $500,000 for this purpose.
The CIRM has a more attractive idea. We propose instead to implement a detailed plan, utilizing LIBOR fixing options, that reconfigures risk protection to the client’s benefit. In the first year, we calculate, self-insurance will be prudent: no cap is needed, and none is purchased, producing immediate cash savings. In year two, however, market conditions will become less friendly. For year two, we advise buying greater protection, a lower cap at 5.50%. Then, if conditions improve, for year three we will purchase a higher cap, without sacrificing overall three-year protection.
Despite rising interest rates, The CIRM’s deployment of LIBOR fixing options keeps year-one interest costs below 4.50%. When interest rates peak in year two, the 5.50% cap kicks in, giving our client a rate of return of 43%. Year three’s higher (and unused) cap produces still further economies.
One of the project partners is a large life insurance company. Institutional clients tend to make institutional decisions. In this case, the insurer is pressuring the developer to enter into a “no cost” collar. Truth be known, there is no such thing as no-cost!
The CIRM advises the partnership, unequivocally, what to do and (more importantly) what not to do, given the current shape of both yield curves. Our analyses and recommendations persuade both the client and (again, more importantly) the insurer to follow a flexible plan sensitive to changes in the economy while providing a known worst case that is acceptable to both.
Without the floor, precise, short-term elections in a falling rate environment saves the partnership over $3,000,000 including the cost of the cap.
It’s late 2000 and we’re retained to manage the interest rate risk on a to-be-built office building. We’re excited, our client borrower is excited, and so is the institutional equity partner, who would like rate protection. The budget is 6.75% LIBOR, and the institutional equity partner wants a cap in place for the first loan draw. Easy! The cap is purchased, set to end in March 2003. The construction loan is $40.5MM and there is substantial equity to the tune of $17MM. All of the LIBOR options from the construction lender are available, from one-month to one-year.
Well, build it and they don’t always show up. Almost three years later, the 365,000 SF office building is complete, but only 20% leased. This is when construction lenders are sometimes hard to live with. During ’01, ’02 & ’03, interest rates did nothing but fall. LIBOR during that period of time fell from approximately 6.77% to 1.30%. That’s quite good for carry costs but 20% occupancy doesn’t quite make it.
A little more equity is required…thank goodness it is an institutional equity investor. The construction lender is happy with additional funds, and provides a three-year loan extension. They also insist on a 2% LIBOR floor. Rats! LIBOR is still 1.30%. The same institutional partner who wanted rate protection when LIBOR was more than 5% higher no longer wants rate protection. With one-month LIBOR being 1.30% and at that time, one-year LIBOR being 1.34%, there was nothing to do.
However, given the 2% LIBOR floor, there was something very important to do. Since the floor implied there was no benefit from fixing long, it was critical to monitor the interest rate markets so that when one-year LIBOR got to 2%, regardless of what one-month LIBOR was, this was the time to fix the loan. That occurred in May 2004. The entire loan was then fixed for one-year. Of course, this occurred during the “measured” period of Alan Greenspan’s tightening binge and during the next year, rates rose substantially, averaging slightly more than 3% LIBOR.
Just by monitoring the market, The CIRM saved the client 100 basis points — over $400,000 — on the outstanding loan balance for one year. It was never envisioned that the loan would have to be extended and modified, but The CIRM’s ability to be flexible and interpret changing situations saved our client multiples of our retainer fee with one decision that was not anticipated to be required when we were engaged. The CIRM’s ability to understand changing circumstances and loan situations is unparalleled.
In 2005, the project finally leased up and sold. It could have been a better real estate story (real estate markets do change), but it certainly could also have been a much worse finance story (interest rates change)!