By Martin Mulligan, managing partner, VUCA Treasury
The past few weeks have delivered a sharp reminder that interest rate risk never fully goes away, it merely lies dormant for a while. Following the Bank of England’s most recent policy meeting on 19March, the daily trading range on the 3-year GBP swap exceeded 40 basis points on two of the three subsequent sessions. To contextualise just how extreme that is: in the prior 12 months, only two individual calendar months had produced a monthly range as wide as what we saw compressed into a single trading day.
The consequences for real estate borrowers and their hedging costs have been immediate and severe. Since the end of February, the premium on a EUR 25m interest rate cap struck at 2.75% has risen from approximately €50,000 to €300,000, a sixfold increase in weeks. In sterling, a GBP 25m cap struck at 4.75% has moved from £30,000 to £275,000 over the same period. For those considering vanilla swaps, 3-year GBP rates have risen from 3.35% to 4.20%, while the equivalent EUR rate has moved from 2.08% to 2.55%. The forward curve has steepened materially and implied volatility, a key input into interest rate cap pricing, has ratcheted higher with it.
Over the past year, many real estate investors had grown increasingly comfortable with interest rate risk. Markets were pricing in a gradual easing cycle for the UK through 2026, and a prolonged period of stable, low rates in the Eurozone appeared to be the base case. That consensus has been dismantled by the war in Iran. Markets have moved from pricing in near-term cuts in the UK and no change from the ECB to attaching a 60% probability to a 25bp move up at the upcoming April policy meetings of the Bank of England and ECB.
For real estate borrowers, the impact differs materially depending on where they sit in the asset lifecycle. Development facilities have traditionally been left unhedged, given their short tenor, uncertain drawdown profiles, and the absence of stabilised cash flow to service a loan. However, the growing dominance of non-bank lenders, many of which carry back-leverage on their own balance sheets, has changed this and those lenders increasingly pass the hedging requirement down to borrowers as a condition of finance.
For investment assets, the challenge is more straightforward in structure if not in execution. A stabilised asset with fixed-income characteristics, partially financed by floating-rate debt, needs visibility over net income particularly where the lender has imposed an interest cover covenant. Here, the question is not whether to hedge but how to size and structure the hedge given current pricing. Understanding the precise rate level at which a breach becomes possible and therefore the point at which the sponsor loses control of the asset is the essential first step before selecting any instrument.
For borrowers facing a refinancing within the next twelve months, the calculus is different again. With market levels elevated and the duration of the current volatility regime uncertain, locking in a long-term hedge today may prove expensive if conditions normalise. Swaptions, which provide the right, but not the obligation, to enter a swap at a predetermined rate, offer a way to cap refinancing risk without committing fully to today’s elevated levels.
Across all three categories, one principle applies: when business risk is elevated, financial risk should be minimised. For investors without a contractual obligation to hedge for the full term of a facility, a pragmatic response has been to place short-dated hedges, typically nine months to one year, through the end of 2026. This creates breathing room to monitor the geopolitical and macro environment without leaving the interest expense line entirely exposed.
The fundamental error of the pre-2022 era was treating interest rate hedging as a cost to be avoided rather than a strategic imperative. We are at a point in time where the asymmetry of risk strongly favours protection. The price of that protection has risen sharply but the cost of not having it has the potential to be far higher.
Martin Mulligan is the founder of Vuca Treasury. Since 1994, Martin has structured and sold foreign currency, interest rate and commodity hedges for corporate and financial institutional clients at a number of major banks in Ireland, Australia and the UK. He has also provided subject matter expertise on disputes involving interest rate derivatives. Prior to founding Vuca Treasury, Martin set up and ran the consulting division of a treasury management firm advising firms in the UK and Ireland on all aspects of treasury.
