At a recent self-storage meeting with about 15 facility owners, everyone in the room took a turn sharing something about their business. One owner proudly got up and said he was going through a refinance of his property via a swap with the lender. Another owner asked him what a swap was and how it worked. The first owner then admitted he wasnt really sure, but he was going to get a better fixed rate than his current one.

This is a typical scenario I hear time and again from owners who are signing loan documents and really dont know what theyre getting themselves into. Theyre trusting the financial institution to do the right thing for the borrower (a scary thought). In this article, Ill help you understand how swaps work and explain the attributes of this financial product.

What Is a Swap?

Lets start with defining a swap. A swap is a derivative in which one party exchanges a stream of interest payments for another partys stream of cash flow. The key word here is derivative, which refers to a financial instrument or, more simply, agreement between two parties. The derivative has a value based on the expected future price movements of the asset to which it is linked, called the underlying, such as a share or a currency. The television show 60 Minutes has done several features on financial derivatives, calling them side bets.

There are many kinds of derivatives, with the three most common being swaps, futures and options. A derivative is a form of alternative investment. It is not a standalone asset, since it has no value of its own. However, more common types of derivatives have been traded on markets before their expiration date as if they were assets. The word derivative has gotten some bad press in the past few years since some of the option and futures derivatives were linked to the collapse of the financial market in 2007-08.

Interest-rates swaps provide a financial institution with a mechanism to hedge its bet on where rates will be in the future. Most swaps youll encounter in the self-storage world of financing will take a variable-rate loan (floating) and place a swap contract on top of it, essentially making the rate fixed.

A borrower will receive loan documents that are for a variable-rate loan, typically priced over the London Inter Bank Offering Rate (LIBOR) index. It appears theyre signing up for a variable-rate loan, which they are! However, in addition to those loan documents, there are additional documents that are the swap contract. This contract sits on top of the variable-rate loan, and will essentially fix the rate of the loan.

Understanding the Terms

Borrowers have often told me theyve signed for a 10-year loan, but the rate they quote doesnt seem to be in line with where rates are currently trading. Generally, as the old adage goes, if the deal looks too good, its probably not real. However, in some cases, a swap may be the culprit behind the confusion. What the lender may have done is provide a 10-year-term loan on a variable-rate basis, but then only provided a three- or five-year swap. After the three- or five-year period has expired, a new swap contract can be placed to continue along with the 10-year-term loan.

Unlike a few years ago when the yield curve was flat (and a 10-year rate was virtually the same a five-year rate), rates between a three-year and a 10-year term can differ around 2 percent today. Consider that as of this writing, three-year rates are as low as 4.5 percent while a 10-year fixed rate is in the 6.5 percent range.

Unlike the traditional loan payment you would make on a fixed rate loan (e.g., $2,000 per month for 10 years), a swap payment has a fixed interest rate. However, the monthly payments differ, each based on the number of days in the month. On the $2,000 per month example, a swap payment would be $2,013 in January, $1,904 in February, and so on. Months with 30 days would be approximately $1,992. The 12-month average payment would be $2,000.

Beware of Penalties

Since a swap contract is set for a specific time period, a prepayment breakage penalty comes into effect if its broken before term. This is important to know since this type of financial product may not be as flexible as many think. Most borrowers want the longest fix-rate term possible to lock in the rate. But a lot can happen in 10 years, so you have to be even more careful when youre entering into a long-term swap deal.

A swap is great if you dont need to alter it during the term. However, its important to remember that unforeseen life events do happen. Consider that a divorce could force a sale, or a partnership may dissolve, both of which are unfortunate but common events that lead to the need for breaking a swap contract.

One way to strategically offset the risk of a long-term swap is to break the 10-year-term loan into two five-year swap contracts. In reality, you only have a five-year fixed rate. At the end of the first five-year period, you simply re-swap your remaining term loan for another five years. Alternatively, depending on the circumstances, you may also choose to refinance the loan with another lender, this time with no prepayment or breakage fee.

Currently, were seeing interest rates near historical lows, and this has many concerned that in five years when their swap re-prices the rate will be much higher. In fact, there exists a delicate balance between the optimal interest rate and flexibility of options. Consider that a five-year swap contract is priced approximately 1 percent lower than the 10-year equivalent swap today.  

For example, if you were able to get a 10-year-term loan for $2 million with a 10-year swap contract at 6.5 percent, the total outlay over the 10-year period would be approximately $1,620,480. If you decided to get that same 10-year-term loan with two five-year swap contracts, you would only pay a 5.5 percent interest rate for the first five years. The rate would have to rise to 7.5 percent in the second five-year period before the borrower would pay the same as if he did the 10-year swap to begin with. And he would have the added benefit of being able to sell the property or refinance it at the end of the initial five-year period of the loan.

Consider All Your Options

Most financial institutions tell borrowers swap contracts can be assumed and, in theory, this may be true. But in practical application, its often difficult to achieve. In most cases, the adjustable-rate loan underneath the swap contract can certainly be assumed. However, its ultimately often up to the discretion of the financial institution whether to allow the assumption of the swap.

In fact, theres typically language in the swap-contract documentation that provides the financial institution with outs if the assumption doesnt work to its financial advantage. In practical application, Ive not yet witnessed a financial institution allow for a loan assumption when a swap contract is in place, because lending intuitions typically prefer the seller of the property to pay the swap-breakage fee.

The amount of the breakage fee is onerous and generally becomes cost-prohibitive for the transaction at hand. Im certain lenders would refute my previous comment, but if there isnt some financial advantage for doing so, my experience is that an assumption will not be approved.

Should You Swap?

So why are lenders using swap contracts as a mechanism to fix rates for borrowers? The simple answer is they make more money on the loan by hedging and placing this side bet. It would be much easier for a borrower to sign less paperwork and not get dragged into yet another financial product thats difficult to fully understand, but the easiest solution is not always the one thats readily available.

If youre considering entering into a swap contract to fix the interest rate on a variable-rate loan, its prudent to have a commercial-mortgage professional along with your attorney advise you during the process and take a close look at the documents. A swap can be useful financial tool; however, the key to executing a loan with a swap, like many other things in life, is asking many questions to the parties involved so you really know what youre getting into.

David Zorich is a senior vice president at The BSC Group, where he provides mortgage brokerage and financial-consulting solutions to commercial real estate owners nationwide. He can be reached at 949.232.5997; e-mail [email protected]; visit www.thebscgroup.com .