Different Types of SWAP Contracts & their Benefits
Updated: Mar 3
A SWAP contract is a financial agreement between two parties that involves exchanging future cash flows. In the context of commercial real estate mortgage lending, a SWAP contract can be used to manage interest rate risk.
When a commercial property owner takes out a mortgage, they typically agree to pay a fixed or variable interest rate to the lender over a set period of time. However, if interest rates rise during that time, the borrower may end up paying more in interest than they anticipated, which can put a strain on their finances.
To mitigate this risk, the borrower can enter into a SWAP contract with a third party, such as a bank or other financial institution. The SWAP contract involves the borrower exchanging their fixed or variable interest rate payments with the third party for a set period of time. In return, the third party pays the borrower a rate that is based on a different interest rate index, such as the London Interbank Offered Rate (LIBOR).
For example, let's say a borrower has a $10 million commercial real estate mortgage with a fixed interest rate of 5% per year. They are concerned that interest rates may rise over the next few years, which would make their mortgage payments more expensive. To manage this risk, they enter into a SWAP contract with a bank. Under the SWAP contract, the borrower agrees to pay the bank a fixed rate of 4% per year, while the bank agrees to pay the borrower a rate based on the LIBOR index.
If interest rates rise, the borrower's mortgage payments will increase, but they will also receive additional payments from the bank under the SWAP contract. If interest rates fall, the borrower's mortgage payments will decrease, but they will also receive less from the bank under the SWAP contract.
In summary, a SWAP contract can help commercial real estate borrowers manage interest rate risk by allowing them to exchange their fixed or variable interest rate payments for payments based on a different interest rate index. This can help borrowers avoid financial strain if interest rates rise unexpectedly during the term of their mortgage.
Types of SWAPs: There are several types of SWAP contracts, but the most common types used in commercial real estate mortgage lending are interest rate SWAPs and currency SWAPs. Interest rate SWAPs are used to manage interest rate risk, while currency SWAPs are used to manage currency exchange rate risk.
Duration: SWAP contracts can have different durations, ranging from a few months to several years. The duration of the SWAP contract should match the term of the underlying mortgage or debt instrument to ensure effective risk management.
Counterparties: The parties to a SWAP contract are known as counterparties. In a commercial real estate mortgage lending context, the borrower may enter into a SWAP contract with a bank or other financial institution, while the lender may enter into a SWAP contract with a third-party investor or hedge fund.
Credit Risk: SWAP contracts involve credit risk, which is the risk that one of the counterparties may default on their payments. To mitigate this risk, counterparties may require collateral or other forms of security to be posted.
Termination: SWAP contracts can be terminated early by either party under certain conditions, such as if the underlying mortgage is paid off early or if there is a default or insolvency event involving one of the counterparties.
Accounting Treatment: SWAP contracts are usually recorded on the balance sheet as either an asset or a liability, depending on whether the contract is in a net asset or liability position.
Overall, SWAP contracts can be an effective tool for managing risk in commercial real estate mortgage lending, but they can also be complex and involve significant legal and financial due diligence. It's important for borrowers and lenders to consult with experienced professionals to fully understand the benefits and risks of SWAP contracts before entering into them.
If you have any questions about this article or would like to discuss a scenario of your own with our team, please feel free to contact Colin Dubel at firstname.lastname@example.org or 949-735-6415.