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 wasn’t 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 don’t know what they’re getting themselves into. They’re trusting the financial institution to do the right thing for the borrower (a scary thought). In this article, I’ll help you understand how swaps work and explain the attributes of this financial product.
What Is a Swap?
Let’s start with defining a swap. A swap is a derivative in which one party exchanges a stream of interest payments for another party’s 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 you’ll 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 they’re 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 they’ve signed for a 10-year loan, but the rate they quote doesn’t seem to be in line with where rates are currently trading. Generally, as the old adage goes, if the deal looks too good, it’s 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.