The cost of hedging interest rates has become another blade slashing office landlords’ operating margins. For many, it may be the factor that forces them to sell or declare bankruptcy.

Lenders often require office building owners to hedge against rising interest rates, especially if the borrower has an adjustable-rate mortgage.

A hedge is a kind of insurance policy. The landlord can buy a hedge that will pay a certain amount if interest rates rise to a specified level. The payment offsets, in whole or in part, the extra amount that the landlord has to pay his lender due to higher interest rates.

Over the past year, the price of hedging has risen with interest rates, just as office occupancy has plummeted and inflation has driven operating costs skyward, leaving office building owners to watch their operating margins disappear.

For many, that has not become a problem yet: many hedges now in place were bought before the U.S. Federal Reserve began boosting interest rates in March 2022.

However, hedge policies usually last only three to five years. Many will expire between now and 2025 and the cost of renewing has jumped by an order of magnitude.

Hedging a $100-million loan for a 3-percent interest level cost $98,000 in April 2019; today the price is $3.48 million, according to Chatham Financial, a risk management firm.

“The cost of interest rate caps has gone from being a minor nuisance to front and center of mind,” Carol Ng, a managing director at Derivative Logic, a hedge advisory firm, told The Wall Street Journal.

Landlords hoping to avoid the cost of hedging when refinancing their loans may be required to pump in more of their own money. The suddenly astronomical cost of hedging is likely to push more building owners into default, the WSJ noted.

In 2021 and 2022, about 60 percent of loans now bundled into securities backed by commercial mortgages carried variable interest rates, data service Trepp found. Just before the Great Recession in 2007, rates also were rising but the share of variable-rate mortgages bundled into those securities was less than 15 percent.

In the COVID era, borrowers and investors bought properties with cheap loans and gambled that rates would stay low for the foreseeable future.

They lost.

A Brookfield Asset Management subsidiary defaulted on loans against two Los Angeles office blocks this year because it decided not to hedge the interest rates. The same fund has two other properties with caps expiring in October. (See “Top Private Equity Firm Defaults on Two Office Towers,”21 Feb 2023.)

Markets have been pricing in a drop in interest rates this year, but the Fed has dismissed the possibility.

Instead, April’s strong job market and wage gains could prompt the central bank to raise its rate yet again in June.

“The risk for real-estate borrowers is that the market eventually comes around to the Fed’s view,” Jackie Bowie, a managing partner at Chatham Financial, said to the WSJ.

For more of our coverage of the ongoing crisis in office real estate, see:

● “Commercial Real Estate in a Tailspin” (20 Oct 2020)

● “Deloitte Abandons More London Office Space” (26 Apr 2022)

● “GM Softens Back-to-the-Office Requirement After Worker Backlash” (4 Oct 2022)

● “Business Office Bust Begins to Bite” (20 Dec 2022)

● “New York City’s Workforce Sharply Shrinking” (24 Jan 2023)

● “Office Occupancy Half of What It Used to Be” (7 Feb 2023)

TREND FORECAST: Brookfield’s default, along with that of Columbia Property Trust in the amount of  $1.7-million (“Office Tower Owner Defaults on $1.7 Billion in Mortgages” 28 Feb 2023), are harbingers of the mounting crisis facing landlords that we explained in our Top Trend 2023 forecast of this next phase in the office building bust (3 Jan 2023): owners of older buildings needing maintenance and repairs will increasingly dump their properties for rock-bottom prices or simply default.

Owners lucky enough to hold newer, more desirable properties still will have to compete for tenants by offering free months’ rent, free redecoration, and other perks.

The office real estate business will recede to become a niche in real estate investing, not the cornerstone it has been for the last century.

For more Office Building Bust trends analysis and trend forecasts, see our ECONOMIC UPDATE in this issue of The Trends Journal.