THE COST OF breaking euro swap contracts entered into by real-estate investors at the peak of the property market in 2006-2007 has now shot up, according to real-estate adviser CBRE.

The swaps were originally designed as a hedging instrument to protect real-estate loans with high loan-to-value ratios (these typically have low interest rate cover) against interest rate rises.

However, as the financial crisis has driven interest rates down to low levels, CBRE says these instruments have become increasing burdens on investors wishing to offload investment properties and in some cases distressed property assets. This trend looks set to continue as weak economic data and the ongoing euro zone sovereign debt crisis continues to push down medium- to long-term euro interest rates.

Irish investors spent more than €13.3 billion on property investments in the euro zone area between 2007 and 2010. In December 2007 the interest rate on a 20-year swap was about 4.9 per cent. At the end of Q1 2012 the equivalent fixed interest rate for the remaining 15.75 years on the swap contract was about 2.7 per cent. To end that contract, a borrower would have to pay an upfront lump sum equivalent to the present value of the additional interest – a surprisingly high 31 per cent break cost for such a swap.

CBRE says that the picture in the UK, where Irish investors spent at least €5.93 billion between 2007 and 2010, was not quite as extreme, as UK swap rates have been slowly increasing in recent months, reducing the break costs somewhat.

However, Irish investors have experienced additional difficulties because, at the peak of the market, many of them took out longer swap contracts than absolutely necessary. They made this choice because long-term interest rates were then lower than short-term rates. Figures in the table show that the longer the swap term, the greater the associated breakage cost.

Caroline McCarthy, executive director of CBRE’s capital markets said the high cost of breaking swap contracts on property loans taken out at (or close to) the peak of the market was now proving a material factor in the work-out strategies of banks considering distressed asset sales. The cost of breaking a 20-year euro-denominated swap taken out in 2007 could wipe a significant amount from a seller’s return.

“In a challenging market, this is frustrating the recovery process as lenders try to deleverage their balance sheets,” said McCarthy. It also penalises investors seeking to dispose of performing assets.”

McCarthy said the irony of this phenomenon was that swaps were intended as an instrument to protect investors from risk associated with rising interest rates. However, at the peak of the market no one anticipated that we would enter such a prolonged low interest environment.

“In working out property loans, banks face considerations relating to provisioning and the current and future prospects for both the underlying asset and the borrower,” said McCarthy.

“The scale of the potential costs of breaking swaps is adding a further significant complication to the process. The key to working one’s way through these situations is understanding the interaction of all the moving parts.”