What are Rate Caps?

For Limited Partner (LP) investors, it’s extremely important to know if a sponsor is using floating rate debt, how they plan to hedge against interest rate risk, and how rate caps work. If you understand rate caps and want to jump ahead to the section which outlines what to look out for as an LP investor, please scroll down to “For LP Investors.”

What is a Rate Cap?

An interest rate cap is an insurance policy based on the index that is tied to a floating rate loan such as SOFR, LIBOR, etc. Real estate operators can purchase these when acquiring a new asset or during the hold period of a deal that has floating rate debt on it.

Rate caps are purchased to hedge against the risk of rising interest rates and create stability when using floating rate loans. As the index (SOFR for example) rises or falls, so does the interest payment on the floating rate loan.

Rate caps can reduce risk on a floating rate deal, but it certainly doesn’t rid the deal of risk entirely. Just ask some of the syndicators who purchased 3 year term rate caps in 2021 that are now getting foreclosed on. If you pay too much for a property, it is pretty hard to make money!

We’ll use the index SOFR in this article as it is the most common metric used on floating rate bridge loans. SOFR (at time of this writing on September 28, 2024) sits at 4.83%.

As a Reminder: All in interest rate is determined by the index (SOFR) and the lender spread.

How do Rate Caps work?

The policy pays out to the purchaser of the rate cap (or their lender) if SOFR reaches the “strike rate”. 

For Example:
- Let’s say an operator purchases a rate cap with a strike rate of 5.5% with SOFR currently sitting at 4.83%.
- The loan is amount is for $10,000,000.
- We will assume a lender spread of 3.5%.
- SOFR rises to 6%.

If SOFR were to rise to 5.499%, the borrower is liable for the full increase in their interest payment. If it were to rise over 5.5%, the issuer of the rate cap policy will start to cover any excess interest payment.

In 2021, the majority of the loans on multifamily deals were floating rate bridge loans. SOFR was at an astonishing .04% on average.

The Federal Reserve was indicating that rates were going to stay compressed. As we know, this did not occur. If sponsors did not purchase a rate cap, operators saw their debt service climb dramatically as interest rates continued to increase. For those who purchased a rate cap, they at least had time to figure out how to proceed before their debt costs skyrocketed, although even that did not save some of them, but it gave them a chance.

You will hear people talk about “in the money” and “out of the money” rate caps.

In the Money Rate Cap: This is when SOFR has exceeded your strike rate, and the insurance is paying you the difference. Some sponsors will purchase an “in the money” rate cap from the onset of a deal. For instance, if their strike rate is SOFR 3% with SOFR currently at 4.83%, the insurance starts paying the difference in debt service immediately at acquisition. These are of course very expensive to obtain and increase your acquisition costs substantially.

Out of the Money Rate Cap: This is when your strike rate is above the current SOFR level. For instance, if someone purchased a rate cap with a strike rate of 5.5% today, they would be purchasing an “out of the money rate cap” since SOFR is currently at 4.83%.

What Affects the Cost of a Rate Cap?

• Term of the Rate Cap – Longer terms cost more, but offer extended protection.

• Strike Rate – The lower the strike rate, the higher the cost. Purchasing a strike rate at SOFR 2% is going to cost much more than purchasing one at 5%.

• Market Volatility – In times of interest rate volatility, rate caps become more expensive because of uncertainty in the markets.

For LP Investors: 

You need to have a good grasp on what debt products are being used on the deal you are considering. If the sponsor is using floating rate debt, and does not have a way to mitigate interest rate risk, you probably need to walk, or run, from that deal.

The length of the rate cap is important as well. Picture This: The Sponsor purchases a one year rate cap in 2021. They are one year through implementing their business plan and then debt costs rise dramatically before they have a chance to increase income sufficiently to cover. This could be the beginning of a death spiral for the property. 

We also have to consider the implications of buying a deep “in the money” rate cap.

When an operator purchases a deep in the money rate cap they are artificially reducing the interest rate on the deal. You can almost think of this as prepaid interest. You might be inclined to think, “great, we start cash flowing in year one”. While that could be true, it's important to understand that artificially lowering the interest rate, even for 3 years, might not reduce risk as much as you think. 

1. Let’s say the 3 year rate cap expires at a bad time to sell or refinance due to high interest rates or market fundamentals.

• Due to the high interest rates, they might not be able to do a refi without having investors contribute more capital.

• Additionally, they might not be able to purchase another rate cap at the same strike without a capital call.

• They might not want to sell the deal if market fundamentals are poor.

2. You should start asking questions like:

• Why can’t the property support a higher interest rate more in line with today’s market? 

• What happens if we need to purchase another rate cap at the expiration of the first one?

• Based on expected NOI in year 3, what is the highest interest rate we could refi at without calling capital? 

• What if NOI projections are missed by 10%, what is the highest interest rate we could refi at?

3. Also, an expensive rate cap increases the cost basis at acquisition somewhat substantially. While not necessarily a deal killer, it’s a notable cost. The operator has to put in even more work to sell the property at a basis that meets projected returns.  An investor needs to ask themselves if the risk is worth it- which is what they should always be asking when evaluating a deal.

All in all, I hope this gives investors something to consider as they look at deals with floating rate debt. I would tread carefully. As we all saw in 2022, interest rates can rise extremely fast!