DERIVATIVES AND HEDGING ACTIVITY (UNITED DOMINION REALTY, L.P.)

6 Months Ended

Jun. 30, 2019

Entity information

DERIVATIVES AND HEDGING ACTIVITY

11. DERIVATIVES AND HEDGING ACTIVITY

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management

of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its debt funding and through the use of derivative financial instruments. Specifically, the Company may enter into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s investments and borrowings.

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and caps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. Interest rate caps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium.

The changes in the fair value of derivatives designated and that qualify as cash flow hedges are recorded in Accumulated other comprehensive income/(loss), net on the Consolidated Balance Sheets and subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During the three and six months ended June 30, 2019 and 2018, such derivatives were used to hedge the variable cash flows associated with existing variable-rate debt.

Amounts reported in Accumulated other comprehensive income/(loss), net on the Consolidated Balance Sheets related to derivatives that will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. Through June 30, 2020, the Company estimates that an additional $8.5 million will be reclassified as a decrease to Interest expense.

As of June 30, 2019, the Company had the following outstanding interest rate derivatives that were designated as cash flow hedges of interest rate risk (dollars in thousands):

	Number of
Product	Instruments	Notional
Interest rate swaps (a)	4	$	315,000
Interest rate caps	1	$	65,197

(a) In addition to the interest rate swaps summarized above, the Company entered into an additional interest rate swap with a notional value of $315.0 million that will become effective in January 2020 upon the maturity of the interest rate swaps summarized above. Additionally, the Company had previously entered into two additional interest rate swaps with a notional value totaling $75.0 million that were subsequently terminated and settled during the three months ended June 30, 2019 in conjunction with the July 2019 issuance of $300.0 million of senior unsecured medium-term notes as disclosed in Note 7, Secured and Unsecured, Net.

Derivatives not designated as hedges are not speculative and are used to manage the Company’s exposure to interest rate movements and other identified risks but do not meet the strict hedge accounting requirements of GAAP. Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings and resulted in no gain or loss for both the three and six months ended June 30, 2019 and 2018.

As of June 30, 2019, the Company had the following outstanding derivatives that were not designated as hedges in qualifying hedging relationships (dollars in thousands):

	Number of
Product	Instruments	Notional
Interest rate caps	1	$	19,880

Tabular Disclosure of Fair Values of Derivative Instruments on the Consolidated Balance Sheet

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Consolidated Balance Sheets as of June 30, 2019 and December 31, 2018 (dollars in thousands):

	Asset Derivatives				Liability Derivatives
	(included in Other assets)				(included in Other liabilities)
	Fair Value at:				Fair Value at:
	June 30,		December 31,		June 30,		December 31,
	2019		2018		2019		2018
Derivatives designated as hedging instruments:
Interest rate products	$	1,616	$	4,757	$	253	$	356

Tabular Disclosure of the Effect of Derivative Instruments on the Consolidated Statements of Operations

The tables below present the effect of the Company’s derivative financial instruments on the Consolidated Statements of Operations for the three and six months ended June 30, 2019 and 2018 (dollars in thousands):

									Gain/(Loss) Recognized in
					Gain/(Loss) Reclassified				Interest expense
	Unrealized holding gain/(loss)				from Accumulated OCI into				(Amount Excluded from
	Recognized in OCI				Interest expense				Effectiveness Testing)
Derivatives in Cash Flow Hedging Relationships	2019		2018		2019		2018		2019		2018
Three Months Ended June 30,
Interest rate products	$	(4,311)	$	282	$	933	$	426	$	—	$	—
Six Months Ended June 30,
Interest rate products	$	(6,522)	$	1,992	$	1,880	$	598	$	—	$	—

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2019		2018		2019		2018
Total amount of Interest expense presented on the Consolidated Statements of Operations	$	34,417	$	31,598	$	67,959	$	61,541

The Company did not recognize any gain/(loss) in Interest income and other income/(expense), net related to derivatives not designated during each of the three and six months ended June 30, 2019 and 2018.

Credit-risk-related Contingent Features

The Company has agreements with its derivative counterparties that contain a provision where the Company could be declared in default on its derivative obligations if repayment of the underlying indebtedness is accelerated by the lender due to the Company’s default on the indebtedness.

The Company has certain agreements with some of its derivative counterparties that contain a provision where, in the event of default by the Company or the counterparty, the right of setoff may be exercised. Any amount payable to one party by the other party may be reduced by its setoff against any amounts payable by the other party. Events that give rise to default by either party may include, but are not limited to, the failure to pay or deliver payment under the derivative agreement, the failure to comply with or perform under the derivative agreement, bankruptcy, a merger without assumption of the derivative agreement, or in a merger, a surviving entity’s creditworthiness is materially weaker than the original party to the derivative agreement.

As of June 30, 2019, the fair value of derivatives was in a net asset position, which includes accrued interest but excludes any adjustment for nonperformance risk related to these agreements, of $1.7 million.

Tabular Disclosure of Offsetting Derivatives

The Company has elected not to offset derivative positions on the consolidated financial statements. The tables below present the effect on its financial position had the Company made the election to offset its derivative positions as of June 30, 2019 and December 31, 2018 (dollars in thousands):

			Gross		Net Amounts of		Gross Amounts Not Offset
			Amounts		Assets		in the Consolidated
	Gross		Offset in the		Presented in the		Balance Sheet
	Amounts of		Consolidated		Consolidated				Cash
	Recognized		Balance		Balance Sheets		Financial		Collateral
Offsetting of Derivative Assets	Assets		Sheets		(a)		Instruments		Received		Net Amount
June 30, 2019	$	1,616	$	—	$	1,616	$	(253)	$	—	$	1,363
December 31, 2018	$	4,757	$	—	$	4,757	$	—	$	—	$	4,757

(a) Amounts reconcile to the aggregate fair value of derivative assets in the “Tabular Disclosure of Fair Values of Derivative Instruments on the Consolidated Balance Sheets” located in this footnote.

			Gross		Net Amounts of		Gross Amounts Not Offset
			Amounts		Liabilities		in the Consolidated
	Gross		Offset in the		Presented in the		Balance Sheet
	Amounts of		Consolidated		Consolidated				Cash
	Recognized		Balance		Balance Sheets		Financial		Collateral
Offsetting of Derivative Liabilities	Liabilities		Sheets		(a)		Instruments		Posted		Net Amount
June 30, 2019	$	253	$	—	$	253	$	(253)	$	—	$	—
December 31, 2018	$	356	$	—	$	356	$	—	$	—	$	356

(a) Amounts reconcile to the aggregate fair value of derivative liabilities in the “Tabular Disclosure of Fair Values of Derivative Instruments on the Consolidated Balance Sheets” located in this footnote.

United Dominion Reality L.P.

Entity information

DERIVATIVES AND HEDGING ACTIVITY

9. DERIVATIVES AND HEDGING ACTIVITY

Risk Management Objective of Using Derivatives

The Operating Partnership is exposed to certain risks arising from both its business operations and economic conditions. The General Partner principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The General Partner manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its debt funding and through the use

of derivative financial instruments. Specifically, the General Partner enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The General Partner’s and the Operating Partnership’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the General Partner’s known or expected cash payments principally related to the General Partner’s borrowings.

Cash Flow Hedges of Interest Rate Risk

The General Partner’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the General Partner primarily uses interest rate swaps and caps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the General Partner making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. Interest rate caps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an upfront premium.

A portion of the General Partner’s interest rate derivatives are owed by the Operating Partnership based on the General Partner’s underlying debt instruments owed by the Operating Partnership. (See Note 6, Debt, Net.)

The changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated other comprehensive income/(loss), net on the Consolidated Balance Sheets and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. As of and during the three and six months ended June 30, 2019 and 2018, no derivatives designated as cash flow hedges were held by the Operating Partnership.

Amounts reported in Accumulated other comprehensive income/(loss), net related to derivatives will be reclassified to interest expense as interest payments are made on the General Partner’s variable-rate debt that is owed by the Operating Partnership. As of June 30, 2019, no derivatives designated as cash flow hedges were held by the Operating Partnership and, as a result, no amounts are anticipated to be reclassified as an increase to interest expense through June 30, 2020.

Derivatives not designated as hedges are not speculative and are used to manage the Operating Partnership’s exposure to interest rate movements and other identified risks but do not meet the strict hedge accounting requirements of GAAP. Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings and resulted in no gain or loss for each of the three and six months ended June 30, 2019 and 2018.

As of June 30, 2019, we had the following outstanding derivatives that were not designated as hedges in qualifying hedging relationships (dollars in thousands):

	Number of
Product	Instruments	Notional
Interest rate caps	1	$	19,880

Tabular Disclosure of Fair Values of Derivative Instruments on the Consolidated Balance Sheets

As of June 30, 2019 and December 31, 2018, the fair value of the Operating Partnership’s derivative financial instruments was zero.

Tabular Disclosure of the Effect of Derivative Instruments on the Consolidated Statements of Operations

During the three and six months ended June 30, 2019 and 2018, the Operating Partnership’s derivative instruments did not impact the Consolidated Statement of Operations.

Credit-risk-related Contingent Features

The General Partner has agreements with its derivative counterparties that contain a provision where the General Partner could be declared in default on its derivative obligations if repayment of the underlying indebtedness is accelerated by the lender due to the General Partner’s default on the indebtedness.

The General Partner has certain agreements with some of its derivative counterparties that contain a provision where, in the event of default by the General Partner or the counterparty, the right of setoff may be exercised. Any amount payable to one party by the other party may be reduced by its setoff against any amounts payable by the other party. Events that give rise to default by either party may include, but are not limited to, the failure to pay or deliver payment under the derivative agreement, the failure to comply with or perform under the derivative agreement, bankruptcy, a merger without assumption of the derivative agreement, or in a merger, a surviving entity’s creditworthiness is materially weaker than the original party to the derivative agreement.