Real Estate Investor Magazine South Africa July 2013 | Page 43

COMMERCIAL
The borrower’s decision as to whether to
obtain a forward or option product will depend
on the borrower’s view of the market rates into
the future.
Market shift instigators, such as commodityprice shifts, disinvestment, catastrophic events
or price shocks, can cause the confidence in
an economy to decline in such a manner that
the cost of money rises steeply. Such rises are
reflected in the yield curve of our bonds from
time to time.
The market’s perception of future inf lation
is the factor which determines the slope of
the yield curve: if the market anticipates that
inf lation shall increase, then the market is
suggesting that there shall be (as a result of such
increased inflation) less money circulating in
the economy.
If there is less money circulating in the
economy, the resultant under-supply shall result
in a higher demand for bonds, forcing the yield
of bonds upwards.
Having established how the yield curve
works, we are now able to relate this (yield)
curve to a borrower’s desire to borrow funds
with some certainty.
By calculating the value of the amount
available for loan repayment, one can calculate
both the value of the loan that can be taken
and maximum interest rate the borrower can
tolerate.
This means that the borrower can agree a fixed
interest rate over a ten year period which will
establish a fixed (certain) cash flow during the
ten year period.
As discussed above, the yield curve – a
summation graphical representation of the
certain 3, 6, 9 and 12 month money market
rates as well as the benchmark government
rates payable in respect of the RSA 157, RSA
168 and RSA 196 long-bonds – is an indication
of where rates are expected to lie during the
investment horizon.
The yield is normally sloped upwards (positively
sloped) in order to portray the lender’s desire to
obtain a higher rate for longer period loans. This
higher rate compensates the lender for inflation
and business associated risk.
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A downward sloping yield curve indicates that
short-term interest rates are high and, as money
becomes more available as a result of investment
in the bond and money markets, lenders expect
the cost of money to decrease over time.
In an inflationary environment, such as South
Africa may experience in the coming months,
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 would be well
advised to monitor the yield curve on a regular
basis and to ensure that their asset managers are
compensating for interest rate fluctuations by
obtaining the benefit of derivative products.

“The benefit of a hedging
mechanism or a derivative
agreement is that the borrower
pays a fixed interest repayment
during the agreed period”
Matching principle
Financiers are able to match the cash flow needs
of the borrower by determining with accuracy
the borrower’s requirements and funding
the amount required in a carefully calculated
manner which provides the borrower with a
steady or smooth cash stream.
The repayment is matched to the residual lease
income over the loan period after interest rates
are pegged.
Bearing in mind the two alternative derivative
arrangements which are available, the borrower
can fund the property development through
a fixed rate loan or through an option capped
loan. The latter allows the borrower to repay
the loan in the event that such repayment is
prudent.
In the case of an option product, the borrower
renews the loan periodically and the lender
guarantees that interest rates – over a mediumterm period of 3 to 5 years (and even over
a longer period of 15 to 20 years will remain
within a (narrow) band (or spread) of values.
This has positive implications for the risk
prof ile of the investment as the standard

deviation of an investment can now be reduced
to a narrower range as a result of the very small
(financial) interest rate risk.
Naturally, property portfolio investments
are even more reliant on such forward rate
agreements and interest rate swap agreements as
the portfolio risk extends to many shareholders
and asset managers have to do all they can to
limit such risk.

Calculating the cost of interest
derivatives
South Africa has a large array of useful and
interesting hedging and derivative instruments.
The essential issue with regard to hedging
or derivatives is that, through a series of
calculations, lenders or funders can work out
a flat interest rate for as long as fifteen years,
which fixed interest rate will be payable by the
borrower for the length of the loan period.
The outcome of this is that the equity investor
can expect to receive a f lat earnings yield
throughout the period of the investment,
creating a certainty about his or her investment
in what may have otherwise been an uncertain
investment paradigm.
The benefit of a