The use of interest rate derivatives allows geared property companies to:
- Repay their floating-rate loans and obtain a fixed-rate loan from an alternative financier for a specified period; or
- Swop out of the floating-rates agreement incumbent within their present loan agreement by entering into an agreement with a third party who provides a fixed-interest-rate derivative product.
In either case, the company obtains the benefit of fixed interest rates for a specified period and can guarantee shareholders a smooth return.
Derivatives can be divided into two groups:
- Forward products, which fix the borrower into a forward rate of interest, regardless of market fluctuations. These are called interest rate swops or forward rate agreements.
- Option products, which introduce flexibility into the repayment arrangement and allow the borrower to repay the loan at the borrower's option. Normally, such an option attracts a cost premium of about 2%, in view of the risk that the lender faces by having to face the possibility of an early repayment.
The borrower's decision whether to obtain a forward or option product will depend on the borrower's view of future market rates.
Market-shift instigators, such as wars or price shocks, can cause the confidence in an economy to decline so much that the cost of money rises steeply. Such rises are reflected in the yield curve.
The yield is normally positively sloped to show the lender's desire to get a higher rate for longer-period loans. This higher rate compensates the lender for risk.
A downward-sloping yield curve indicates that short-term interest rates are high and, as money becomes more available because of investment in the markets, lenders expect the cost of money to decrease.
In an inflationary environment, the yield curve is positively sloped, indicating that the cost of medium- to long-term funding can be expected to increase.
Investors in the property sector are advised to monitor the yield curve to ensure their asset managers are compensating for interest rate fluctuations.