Europe’s commercial real estate owners, saddled with 1.9 trillion euros ($2.5 trillion) of debt, may be forced to make billions of euros in cash payments under planned laws that would treat them like hedge funds.
Property fund managers could face demands for cash collateral to cover bets on interest-rate movements, under European Commission proposals to regulate the derivatives industry. Interest-rate swaps were attached to about 130 billion pounds ($204 billion) of U.K. real estate debt at the end of 2009, according to a De Montfort University study. Most would be subject to such a payment.
“There is a perfectly genuine risk at this point that the commission will win the day and, not only real estate funds, but also European real estate investment trusts will be caught.” said Peter Cosmetatos, finance director at the British Property Federation.
The EU aims to lower economic risks caused by derivatives after instruments such as contracts insuring mortgage-backed bonds fueled losses that led to the worst recession since the Great Depression. The current proposals cover businesses including real estate, private equity and hedge funds.
Real-estate buyers use swaps to secure a fixed interest rate when taking out a floating-rate loan to buy a building. That helps ensure that the property’s rental income will be enough to service the loan, even if rates rise unexpectedly. Under the EU plan, a demand for payment, or margin call, could result if rates go the opposite way than the swap anticipates. Businesses unable to pay could be declared to be in default.
“That would be a catastrophic result for property businesses using derivatives like interest-rate swaps,” according to a European Property Federation study on the proposals. “Some would be unable to fund margin requirements and could default on their borrowings and risk insolvency.”
The British Property Federation wants to determine whether all European property companies, including REITs such as Land Securities Group Plc and Unibail-Rodamco SE, would be governed by the proposals, Cosmetatos said. Members of the commission and real-estate industry representatives will meet in the “next few weeks” to clarify the issue, Chantal Hughes, a commission spokeswoman said by e-mail.
The new laws, which must be approved by the European Parliament and member states, would probably come into force by the end of 2012, Hughes said.
Most of the investors that bought shops, offices and warehouses during a five-year spree through mid-2007 used interest-rate swaps to protect their mortgage repayments from rising interest levels. The rates fell instead, triggering liabilities to the other party in the swap. If the proposed regulations had been in place, U.K. borrowers would have needed to put up collateral of about 10 billion pounds to cover swaps that moved the wrong way, William Newsom, head of valuation at Savills Plc, estimated in June.
“Virtually all interest rate swaps are out of the money,” said Nicholas Scarles, the London-based finance director for Grosvenor Group Ltd., which manages 10.2 billion pounds of global properties. “To have to suddenly find that cash is not only unexpected, but it could be a reasonably large requirement.”
Currently, real estate borrowers aren’t required to post collateral on interest-rate swaps that have moved the wrong way unless they break the contract. While the liabilities are reported on company accounts, they aren’t usually paid if the swap is held to its maturity date.
“They’re potentially including organizations that shouldn’t be there,” Scarles said. “By including them, additional risk would be created.”
If the proposals are adopted, property investors could choose to take out fixed-rate loans instead if banks make them available, said Bill Bartram, head of property risk at finance broker JC Rathbone Associates Ltd. Such agreements offer less flexibility than floating-rate loans with swaps, he said. Most banks give floating-rate loans against commercial real estate.
“If property companies choose to leave their exposure un-hedged because of this, it will make them a more risky proposition,” Bartram said. “It means the property sector’s currently very low contribution to global systemic risk will increase.”
The EU’s proposals require most derivatives trades to be processed through third-party clearing houses that will also hold the collateral put aside by companies. That will give regulators greater ability to monitor the market.
The total amount of debt secured against European commercial properties was about 1.9 trillion euros at the end of last year, according to DTZ Holdings Plc. While there is no available estimate for the portion of debt hedged by interest-rate swaps, the De Montfort study said that more than half of the U.K. portion is attached to them. About 85 percent of the surveyed lenders required swaps to be in place on new loans.