Early in 2022, Origin’s investment committee became increasingly concerned about rising inflation, believing that interest rates would follow suit. As risk managers, we can’t control macroeconomic trends, but we can mitigate the impacts of those trends. We decided to hedge against what we saw as the impending increase in the cost of debt, using a hedging strategy called swaptions, purchasing these specialized options for $18 million. We also executed forward-dated interest rate swaps on $500 million of debt that allowed us to fix the cost of debt on future financing.
Over the course of last year, we garnered a total of $43 million in gains—including several million in unrealized swaptions—that could be deployed to offset higher interest costs if rates remained elevated. Not only did we protect our Funds from interest rate increases, but investors also saw a material gain across our Funds as a result.
We have written about how and why we decided to take this approach in other articles last year—and earlier this week, the Wall Street Journal wrote about it, too, calling it an audacious move and saying it was “virtually unheard of” for smaller, privately held firms to employ derivatives this way. While we continue to own swaptions today, we don’t know of any of our peers doing this. Maybe it was audacious. But we consider it key to being responsible risk managers.
Using Swaptions to Protect Our Funds
A swaption is, essentially, an option to enter into an interest rate swap at a future date. If rates increase above the option strike price, we exercise our option and receive payments that offset the costs of higher interest rates. (If rates stay below the option strike price, we don’t exercise the option and the premium is a sunk cost.)
Because options to secure fixed-rate financing on our development assets are relatively limited, we typically capitalize ground-up development deals with variable-rate construction loans. Employing strategies like swaptions and swaps meant we could hedge against the risk of interest rates rising and remaining high during a period when we couldn’t fix our debt.
It’s important to think of this as a form of insurance. If you’re a homeowner, you don’t complain about paying your insurance policy just because your house doesn’t burn down. We all saw what happened last year: a series of aggressive interest rate increases by the Federal Reserve in an attempt to cool 40-year highs in inflation. We invested our “premium,” and while there was risk of never utilizing that “insurance,” we were willing to take on that expense rather than lose hundreds of millions of dollars in value if interest rates rose even higher, taking our development costs with them.
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Not Speculation—Just Solid Strategy
Our timing was good because we had been paying attention. I had predicted increases in inflation and interest rates in December 2021, and as a former derivatives trader, I initiated a discussion around the use of a hedging strategy. But my team and I never viewed it as speculative, as a bet on the market, or as a one-off opportunity to generate and pocket the cash. We’re not a hedge fund, of course. We choose to leverage these types of hedging tools, but we don’t have to rely on them as a quick-fix cash infusion to make up for poor money management.
From our perspective in 2022—going back to that risk-management mindset—we had no intention of allowing something like spiking interest rates to destroy the value in our Funds. Of course, the likelihood of that happening is small. But we would consider it a breach of our fiduciary duty to do nothing. We will continue to use hedging, whether it’s in the form of swaps or swaptions, for the foreseeable future this year to mitigate the impact of higher interest rates. We stand by our commitment to be good stewards of investors’ capital, and we believe that it is a prudent approach and a key component of risk management.
Swaptions Are Part of Protecting, Growing Wealth
Current gains created through our decision to acquire swaptions as part of our overall hedging strategy stand at $34 million, as of Dec. 31, 2022, and we hold them in four Funds: the IncomePlus Fund, Qualified Opportunity Funds I and II, and Growth Fund IV.
As our deals progress through pre-development, get construction financing in place and get closer to breaking ground, we will employ additional hedging strategies such as swaps. In doing so, we can consider terminating these swap options—and if they are at a profit or a gain relative to the premium that we paid, we can use that cash as additional hedging. Our work isn’t done yet. As our Funds grow, we continue to look at different ways to hedge rate risk.
Shortly after the publication of the Wall Street Journal article, an investor asked us whether investors would share in any of the gains we have made through this hedging strategy. Our answer: We did this for the benefit of our investors, and you get 100% of the benefits of this strategy. Our goal in taking these actions is to protect the wealth of our investors even as we apply our expertise to grow that wealth as well.
