Senior Living Business: Variable-Rate Vs. Fixed-Rate Financing--

Providers Need to Know The Ramifications And The Rules  

Up until the last few years, almost all senior health and housing financings were issued on a 30-year, fixed-rate basis. Fixed rates were simple to understand; variable rates were viewed as risky for borrowers. As the market has matured, there has been a much greater acceptance of variable-rate products. “Banks, insurance companies, and other credit providers have become more comfortable with the nature of senior health and housing financings and with their credit worthiness, which has opened the door to the use of other types of products, including variable rates,” says Scott Smith, managing director of Cain Brothers in New York City and head of its Capital Markets Group.
“While the academic approach is to have a balance of fixed rate and variable-rate debt,” he adds, “a lot of startup projects build up pretty substantial cash balances as they collect entrance fees over time. There’s some logic to the view that they can invest that money, and the investment returns will correlate to the cost of their variable-rate debt. And by keeping their eyes on the mix [of fixed- and variable-rate debt] and managing it properly, they should be able to create a positive return.”

Opting for variable rates
Before taking on its initial financing, an organization should always lay out a cohesive plan as to how much variable-rate exposure it wants to have. “Typically, institutions will pick a target at the front end of a transaction,” says Smith. “When they hit their target, they can then manage the financing in either of two ways:
1. Issue some variable-rate debt and some fixed-rate debt; or
2. Issue the entire financing as variable-rate debt but then use some of the available risk- management products, such as interest-rate swaps, to convert a portion of the variable- rate financing to a fixed rate.

The second option above has become the more prevalent choice. It’s probably more cost-effective. “And when you’re done,” according to Smith, “you have a target mix that meets your needs. Interest-rate swaps offer a lot of flexibility to manage the total amount of exposure,” he explains. “If you decide a year into the financing that you need more or less variable-rate exposure, you could either decrease or increase the size of your swap to meet that objective.”
In fact, people’s needs change over time. What may have seemed like a good target mix at the time of the initial transaction may not continue to be a good target mix five years — or even 12 months — down the road. But once you swap into a fixed rate, that portion becomes fixed for the selected length of time and you’re locked into those economics. If you choose to reverse those economics at some point in the future, you’ll be subject to the market variables at that point in time. “That may have some implication,” says Smith, “but you’re still able to either increase or decrease the size of that swap without completely redoing your financing. You can swap back to a variable rate if you wish. The market may have moved in your favor or against you, but you can use the tools available to you – i.e., the swap contracts or the removal of the swap contracts – to meet your target.”
Smith advises his clients that they need to have a plan, and they need justification for that plan. “When you put your financing in place, there should be some rationale for why you were willing to accept a certain amount of variable-rate debt,” he says. “And that’s something that should be discussed not only among management but also with governance and the institution’s board and whomever else has input on how the financing will be structured.”
In addition, Smith also feels it’s important to have a policy in place to reevaluate the outstanding debt from time to time. “When rates move against you in a variable rate structure, you can’t really go back and redo the loan,” he says. “You have to look forward and think about what to do next and what the mix should look like from that point forward. You can’t expect to go back and simply undo a bad decision.”

Following the rules
In terms of audit reporting, there are very specific rules to follow when accounting for swap and interest-rate management products. The Financial Accounting Standards Board adopted very detailed accounting and reporting standards for derivative instruments and hedging transactions (FAS 133), which went into effect back in 2001. These “hedging rules” were developed to resolve past inconsistent standards and practices and provide greater transparency. With respect to FAS 133, Smith advises clients to have all their ducks in a row on day one. “You can’t comply retroactively,” he says.
So there’s a right way and a wrong way to account for variable-rate and associated products. “Basically, your auditor gives you a bunch of hoops to jump through,” according to Smith. “If you jump through those hoops, you get favorable accounting treatment and can minimize the variability in your financial statements. If you don’t jump through the hoops, you get unfavorable treatment and may get stuck with some sort of non-cash items that flow through your financial statements — and that may have an unintended consequence.”
Historically, though, accountants are known to change the rules over time. It’s important to know today’s rules and, if they change, to be prepared to change with them. You’ll have to be on the alert for possible rules changes, however, because your auditor won’t watch this for you. “An auditor’s purpose in life is to look over your shoulder after the fact,” says Smith. “You need either experienced management to monitor your instruments or an outside advisor to keep an eye on the situation.”
Cain Brothers, in fact, realized several years ago that clients were having a very difficult time monitoring these instruments without someone to help them on, say, a quarterly basis. So besides helping clients structure deals, bonds, swaps, and other things, the company also provides that monitoring service.

Today’s idiosyncratic market
Certainly what’s happening today in the credit markets — specifically, the fallout related to sub-prime mortgage loans — is filtering through to the senior health and housing sector. “No one is immune,” says Smith. “It appears that investors are pulling back from every market. You may have credits that have been underwritten with no problems for years — and continue to have no problems — but suddenly the number of investors that want to buy that paper has been reduced, because those investors have lost money in other parts of their portfolio.”
Most big investors, of course, don’t buy just one type of investment. And when liquidity dries up in one market, it tends to affect other markets. Now, as investors are circling their wagons and focusing on quality, they seem to be throwing the baby out with the bathwater. “They don’t want to buy anything that has risk, because they’re having a hard time assessing what that risk is,” says Smith.
Because of the current turmoil in the bond market and the stock market, it has become relatively much more expensive to issue a fixed-rate bond than to issue a variable rate bond. Notwithstanding the difference between fixed and variable rates, the “credit risk component” of the interest rate has gotten much greater on the fixed-rate side. Investors are not willing to take on a 30-year risk without charging a much larger premium.
“All things being equal, it’s much cheaper to issue variable-rate debt on its own than it is to issue fixed-rate debt and swap it back to variable,” says Smith. “In a side-by-side comparison, the natural variable rate will be roughly 100 basis points, or 1 percent, cheaper. The same logic follows for the converse — issuing variable-rate debt and swapping it to fixed. That will be about 100 basis points cheaper than issuing straight fixed-rate debt. Now that’s a big generalization – the actual result will be different for everyone – but it’s a pretty fair rule of thumb.”
While other firms that advise clients on how to structure these types of transactions — and do not act as a principal — may also provide that kind of monitoring service, it’s not common for the big money-center banks to do so. The banks that provide the actual contracts, whether the transaction is a swap or another type of instrument, would have a conflict of interest. “They sit on the other side of the transaction,” says Smith. 
 
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