What is an Interest Rate Cap?

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Certainly for the latter part of 2021, and for most of this year, inflation and interest rates have been capturing the economic headlines. Real estate and other investors have been carefully following the deliberations of the Fed when it comes to when and by how much to raise interest rates in order to try and rein in inflation.

Given that higher interest rates can force up the cost of borrowing and potentially impact the profitability of syndicated real estate investments, this week we're going to have a look at how professional investors mitigate and manage such risk by purchasing interest rate caps.

What is an interest rate cap?

An interest rate cap is essentially an insurance policy on a loan which has a floating interest rate, most frequently the Secure Overnight Financing Rate (“SOFR”).

What are interest rate caps used for?

Interest rate caps are used by borrowers and are a commonly used interest rate hedge at all stages of a real estate cycle. They are particularly used for shorter term debt on transitional assets which require flexibility for a refinance or sale. Interest rate caps have a pre-determined upfront payment and no early repayment penalty,

Caps permit an investment to be underwritten to an interest expense, if this is required, and lenders offering a floating-rate typically require a borrower to purchase an interest cap as a condition of a loan.

What are the main components of interest rate caps?

An interest rate cap has three primary economic terms:

• loan amount covered by the cap (usually called the “notional”)
• duration of the cap (the “term”); and
• level of interest rates (the “strike rate”) above which the cap will pay out.

What determines the cost of an interest rate cap?

The above mention three variables determine the cost of an interest rate cap to the borrower;

• Amount of loan or so-called “notional”: generally, a cap for a larger amount is more expensive than one with a smaller notional. Broadly speaking the cost of a cap for $50M will be around twice that of a cap for $25M;
• Term: is the length of time that the cap is protecting the borrower; as you’d expect the longer the term, the more expensive the cap. Typically,, each additional month of the cap term will cost somewhat more than the previous month;
• Strike rate: is the interest rate at which the interest cap provider begins to make payments to the cap purchaser or borrower. When the strike rate is relatively low, it’s more likely that a cap provider will need to make a payment during the term. Naturally, caps with lower strikes are more expensive than ones with higher strike rates.

What else can cause changes in the interest cap price?

Changes in one or more of the above variables can change the cap price but cap pricing may fluctuate over time based on changes in:

• Volatility of interest rates: high levels of interest rate volatility implies a greater likelihood that rates will spike higher than the key rate, which would result in a larger pay out by the cap seller;
• Changes in key rate: reflects the expectations for SOFR over the term of the cap. As the key rate increases, the likelihood of a pay out to the cap purchaser increases, which will encourage an increase in the cap cost. On the other hand, a decline in the key rate is likely to result in a decline in the cap cost;

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• Term requirements of lender: lenders will often require the term of a cap to be coterminous with the initial term of the underlying loan, although may agree to an initial cap term that is less than the initial term of the loan provided there is provision for extension;
• Strike rate requirements of lender: a lender will often specify the strike rate for the cap; this is usually calculated by using a minimum DSCR (debt-service coverage ratio) based on lender underwritten NOI (net operating income). It’s possible to have a structure with a strike rate that increases over time (“step-up” strike) to reduce the cost of the cap;
• Credit rating: many lenders require the cap provider to have a minimum credit rating from major agencies such as S&P, Moody’s and/or Fitch). In the case of a credit downgrade after purchase, a new cap may be required. (so-called “downgrade trigger”). Different lenders may have varying degrees of flexibility on these terms depending on their underwriting requirements.

How long does it take to purchase a cap?

The necessary due diligence may take up to two weeks prior to a planned purchase, so that the most price competitive and creditworthy cap providers can be identified.

What documentation is required to purchase an interest rate cap?

Purchasing a cap requires a wide variety of information and documentation to be completed, some of which include:

• Information to be able to run background checks: on the borrower, its major investors and officers; documentation needed may include includes tax forms, formation documents, information on the borrower’s ownership structure etc;Regulatory compliance: documents must be completed and signed by the cap purchaser to confirm that they and the cap seller comply with the relevant regulatory statutes;
• Transaction summary: confirming the purchase and its material economic terms, which lender rely upon as evidence of the purchase;.
• Trade confirmation agreement: produced by the cap seller after completion of the purchase, setting out the economic and legal provisions of the cap;
• Incumbency certificate: must be provided by the cap purchaser that attest to the signatory’s ability to execute the trade confirmation, and confirms the authority of the purchaser to enter into the cap;
• Collateral assignment: is required if a cap is purchased as a lender requirement for a loan.

CPI Capital monitors all relevant economic data such as interest rates on a daily basis as it relates to or may affect private equity real estate investment. A large part of being successful in syndicated real estate is mitigating risks as far as possible.

Loans with floating interest rates may be beneficial in certain instances, especially when it appears that rates are likely to be volatile over a period of time. But professional entities such as CPI Capital will often purchase an interest rate cap to hedge against unexpected interest movements in order to protect its passive investors from wide swings in the amount of loan repayments with a view to maximising profits.

Yours sincerely,

August Biniaz

CSO, COO, Co-Founder CPI Capital

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