Effective interest rate risk management can often drive success or failure for leveraged investors. Fortuitously, CME Group has Eris SOFR swap futures for investors to easily meet the many challenges in today's dynamic interest rate market. From aggressive FOMC rate hikes from near zero percent to over five percent; cessation of LIBOR at the end of June 2023; and evolving banking events; challenges abound. Complicating matters further, interest rate volatility also moved to a higher plateau, driving margin requirements and capital usage higher as well. Correct product selection can improve hedging robustness and capital efficiencies.
REITs – Leverage, Cap Rates, and Returns
Real Estate Investment Trusts (REITs) are traditional leveraged investment vehicles that must focus on their interest rate hedging needs. REITs use investor funds as well as borrowed monies to purchase real estate assets. The difference in earnings on the assets and the expenses of the debt liabilities is returned to the investors. Getting both the balance of the amount of debt and the cost of the debt is critical to the success of a REIT structure. According to Nareit, a well-known REIT research and data organization, the debt to market asset ratio is at its long-term average of 35%, but has been known to be close to 40% a few years ago.
Nareit also noted that many REITs “termed-out” their liabilities, but a considerable amount of floating rate debt remains and roll-down of the existing liabilities to shorter maturities requires new interest rate risk management to manage the growing gap between the longer-dated assets and the shorter duration on the liabilities.
When REIT operating revenues are high on the operating assets, it is possible to absorb higher interest rate expenses on the liabilities. The standard measure for REITs is called a cap rate, which is the ratio of the net operating income of a property to the asset value of that property. With asset prices increasing and costs rising, cap rates have been depressed since 2019. While they have improved from their lows in 2022, worryingly low cap rates have recently recovered but turned lower again. There are a variety of complex factors that drive cap rates and many of them are not immediately controllable.
Download PDF