Local School Country Day of Kenton is known as the premier private school of the area. It bought 25 acres of prime real estate for school expansion on the edge of Kenton which is growing at a record rate. The area around Kenton is projection population growth of 15% a year for the next 10 years. This real estate, purchased 5 years ago, was clearly a good investment for the school. It has allowed the school to build a football stadium, new class rooms, a track, and provide better parking and a much nicer campus. The problem is that even though property values are up by 50% it has very little of the property left to sell or develop. It can sell of only 5 acres, with an estimated value of 10 million if it so chooses, however the board is split on whether to sell or not. The loan the school took out to buy the property and build the facilities was 30 million interest only fixed for 5 years, then floating at 3% above prime for another 15. Having gotten lucky the securitized loan (secured by all the property of the school which is worth much more than the 30 million) interest rates were low and the rate paid was 4.5%, a spread of 1 % above prime for the first 5 years; prime is 4.25% today. In the contract the bank that loaned them the money has the right to force the School to fix half of the balance at 5% above the 15 year treasury rate or hedge the entire amount of the floating rate loan in a separate contract with the original bank or some other financial entity. The hedge must can take the form of a swap or cap on interest rates. If the cap or swap is in place the floating rate on the amortizing loan will be 2 % above prime.
One of the board members proposed the following. Stay with floating rate loan, sell some of the property, get a stand by line of credit to borrow $10mm if necessary at 2.5% above prime (the stand by will cost 15bps if not used) and buy an interest rate cap on a 15 year amortizing floating rate loan for 30 million notional. Is this board member crazy? He argues that this is a better deal since another bank will loan the money at prime plus 2% if the cap is in place at floating treasury If you pay off the original loan you must pay a penalty of $500,000. Your job is to break down the possibilities for the board’s consideration. Compare all the alternatives, why and why not on the implied risks. What do you recommend and why? This will be what the board accepts.
Based upon what you recommended at the time above. now assume 5 years have passed and interest rates have not moved at all, much to the chagrin of most all economic forecasters. With 10 years left on the loan and interest rates still very low (the year 2022 treasury yield curve looks like what it did in October of 2017) the board members are stuck with the choices made 5 year ago. A new hot shot board member says it is time to revisit what we did and evaluate the situation anew for the next 10 years. Given what was done 5 years ago what do you think you should do now?