A generic SwapRent transaction is a “temporary own-rent switching” contract that facilitates the realization of the separation of the “Usufruct Value” from the “Investment Value” of owning a commercial real estate property. The usufruct value is usually best explained by the annual lease rate that a property could command. The easiest way to visualize it is the cost to rent the property or more conveniently viewed by an investor, the cap rate of the income producing property. The investment value of a property is best demonstrated by the actual difference between the cost to own and the cost to rent. Therefore the investment value of a property could be either positive or negative based on the investment sentiments and the interest rate levels on the term structure, i.e. the cost to own at any given point in time.
Exaggerated round numbers are used in the following examples for illustration simplicity.
Let’s say an office building (multifamily, retail shopping center, hotel or industrial building) was acquired in 2003 based on a cap rate of 8% for $40 million with a $28 million first lien mortgage note of 6%. By 2006, the property value has increased to $60 million. Assumed that the owner had entered into a 5-year SwapRent transaction with an investor based on a commercial property index (e.g. NCREIF Property Index, S&P/GRA Crex, Moodys/REAL CPPI, etc.) for 50% of the property’s value, i.e. $30 million (50% of $60 million) as the notional amount.
A SwapRent contract does not have to be tied to any particular property index and it could be used with or without an index. For example, the settlement valuation could be done by simply using various appraisal methods or the real bought/sold transaction prices. We have chosen to use an index method purely for illustration simplicity. Investors in general would usually prefer to have an index-based SwapRent transaction since it would provide much more liquidity in the secondary market so that they could sell the SwapRent contract they own to other investors more easily. The choice of an appropriate index to use would be best covered as a separate topic.
Let’s further assume in 2006 when a SwapRent transaction was entered into by the property owner and an investor, the interest rate swap rate for 5-year maturity was 5%, which represents the cost to own. The SwapRent rate was 3% which represents the cost to rent. There is an annual premium of 2% (difference between 5% and 3%) which represents the investment value for a 5-year horizon through a SwapRent contract. The reason why that the SwapRent rate is lower than the cap rate is because that a negotiated SwapRent rate typically reflects the information of both the actual cap rate of a property and its expected price appreciation for a investment horizon holding period. A lower SwapRent rate indicates a bullish sentiment that the investors expect a high positive price return on an investment horizon date.
During the course of the 5-year period, the property owner received a monthly cash flow of $50,000 (one half of 2% of $60 million) from the investor. At the same time he continued to receive the expected yield of $266,667 in monthly cash flows (8% cap rate of $40 million) and pay the monthly interest of $140,000 (6% of $28 million).
Assume by settlement date in 2011, the property value was determined at $30 million based on the settlement property index value. The 5-year transaction which was put on in 2006 with the initial notional amount of $30 million would generate a loss for the investor of $15 million since the property has lost half of its value ($30 million). The property owner bears the other half of the capital loss of $15 million since he had only hedged one half of the property’s value when it was worth $60 million in 2006. However, he had received $3 million as income during the course of the 5-year period from the investor. So his net loss is really about $12 million only, without considering the tax effects.
The investor would have to cut a check to settle the loss of $15 million to the property owner, on top of the $3 million he had paid in total to the property owner from the $50,000 check every month for 5 years. His total loss is about $18 million.
In this example, the investor seems to be a loser in the deal. It has nothing to do with the SwapRent contract. If the investor has teamed up with another investor and bought the property in 2006 at $60 million through the conventional method of taking over the title, he would have lost the same $15 million through his share by 2011 when they sold the property again at $30 million. During the course of the 5-year holding period, he would have paid a lot higher carrying cost than the $50,000 monthly check in a SwapRent contract. In addition, he would have incurred much higher expenses from transferring the legal title of the property in 2006 and 2011 when he bought and sold the property. His total loss would have been much higher than $18 million.
A SwapRent contract simply carves out the economic interests and financial consequences of this same round-trip investment activity at a much lower cost to the investor and the property owner by avoiding the transactional brokerage cost, related legal bills, property taxes, insurance premium, the expenses to hire a property management company to find renters and fix the property, etc. The low cost would then encourage more trading liquidity in the secondary market among investors. Otherwise, a SwapRent contract does not alter the investment payoff or the reasons why an investor may or may not want to make a particular investment in a property.
The similar property owner as above had borrowed additional $5 million in 2006 at 7% in a second lien when the property was valued at $60 million. His total debt is $33 million. In 2011, he faces a severe vacancy problem in this office building due to the recession in the US. Not only his property is under water by $3 million, he also could not meet his combined monthly mortgage payments of $169,167 ($29,167 + $140,000). His new NOI in monthly cash flow became $135,000 a month. He is $34,167 short every month. He has stopped the monthly payments and the two trust deed notes are now in arrears and non-performing. His bankers are worried as the two trust deed notes were marked to market at a big discount on their books.
Assuming a SwapRent transaction is available at 2011 with similar terms above. An astute investor saw the opportunity and seized it. He first approached the banks and bought the two trust deed notes from the banks at a 40% discount each (60 cents on the dollar). He then turn around and went to the property owner and offered the SwapRent transaction to him. The property owner agreed to give up 75% of the economic ownership through a SwapRent contract (with a notional amount of $22.5 million, i.e. 75% of the current value of $30 million) and hence 75% of the potential appreciation from today’s property value of $30 million to the investor. The investor would then pay the $37,500 monthly cash flows in total every month and perhaps $34,167 of which to the lien holders directly to cover the shortfalls in an arrangement with all parties involved and help the property owner bring the two trust deed notes back to current and performing, hence avoiding an imminent expensive foreclosure.
Since a foreclosure had been avoided and the notes were all brought back to current and performing. The investor got to sell them at par (perhaps even higher than par since the credit of the two notes has been enhanced) and hence pocketed a realized short-term trading gain on the two trust deed notes within a few weeks’ time. He still sits on the 5-year SwapRent contract with the property owner. Since the carrying cost in the commitment of the SwapRent contract is very low ($37,500 a month) he is in no rush to re-sell it. He could either hold on to it and wait for the future appreciation of the property and pocket 75% of the appreciated value either at maturity date 5 years later in 2016 or at any time between now and the maturity date when he finds a good price with another investor or trader through REIDeX.com, the secondary marketplace for all SwapRent contracts.
The reason why the arbitrage opportunity existed for the astute investor was partially attributed to the bureaucracy and reluctance to learn new ways of doing business by some of the regional and local banks. Their preference to do the business in old fashion ways by selling off the distressed assets presented smart and aggressive investors these market opportunities. The banks’ board and shareholders could be quite happy that they stick to their conventional lending business and get out of troubles the old fashion way as long as they could get rid of the distressed loan assets quickly.
Driven by profit making motives, these smart arbitrage investors/traders, in an effort to outbid other investors, would have paid a much higher price for these distressed loan assets than what the banks would have gotten otherwise without the arbitrage traders’ deployment of the SwapRent solutions with the property owners.
By making the extra efforts and adding value to fix up the distressed assets, the smart arbitrage investor/trader was well compensated for the efforts he made to help the property owner hang on to his property. The banks were happy that they had avoided a receivership by FDIC, the property owner was grateful to hang on to his property and his bread-earning means, the investor/trader was even happier with the realized short-term trading profit.
Last but not least, the broker who had put everybody together and engineered the proposed SwapRent transactions should have been fairly compensated for his efforts as well. It would be a win-win deal for all parties involved no matter which way you look at it. Even FDIC, Treasury Department and Congress would have also been thankful that they no longer have to beg for more tax payer’s money for more bank bail-outs. Free market based innovative solutions proved once again it could indeed automatically correct the excesses and abuses in a capitalism society, without the need of the government’s intervention.
As more and more of the free market based SwapRent solutions were put on from 2010 onward to rescue the banks, the property owners by the smart arbitrage investors/traders, the imminent collapse of the commercial property market would be halted and the market would indeed start to turn around due to the buying demand once again. Try to imagine how much more money the eventual holder of the SwapRent contract and the property owner could make by 2016 when the property has appreciated from its starting value of $30 million back in 2011 when this 5-year SwapRent contract was put on.