SS120: What is an Interest Rate Cap?

SS120: What is an Interest Rate Cap?

Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing What is an Interest Rate Cap. Interest rate caps are an important part of real estate financing. In this episode, Charles discusses what an interest rate cap is and why it should be obtained when you are purchasing properties with variable-rate debt.

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Talking Points:

  • During periods of rising interest rates, there are a couple of tools that real estate investors can utilize to hedge the increasing debt service cost of mortgages. Investors who have “floating rate debt” also known as “variable interest rate loans” are able to employ an interest rate cap in order to set a limit (a cap) on their interest rate for a set period of time.
  • What is an interest rate cap?
    • An interest rate cap is a limit on how high an interest rate can rise on variable-rate debt. An interest rate cap is essentially an insurance policy on a variable-rate loan. Interest rate caps offer borrowers protection against dramatic rate increases.
  • How do interest rate caps work?
    • Interest rates on commercial real estate loans are comprised of a nominal spread (what the lender charges for the risk) plus an index (such as the Secured Overnight Financing Rate (SOFR)). For variable-rate loans; the spread is fixed but the index is variable. For example; if the lender has a 3% spread and the index is 1%; the rate to the borrower is 4% but if that index goes to 3%; the rate to the borrower is 6%. If a borrower feels that rates will continue to rise during the term of the loan; they are able to purchase an interest rate cap.
    • There are three main parts to an interest rate cap.
      • 1st is Notional: the dollar amount covered by the cap; the loan amount. Also called the “size” of the cap.
      • 2nd is Term: the duration of the interest rate cap; usually 2 or 3 years, typically shorter than the loan term. The longer the term, the more expensive the cap. Each additional month of a cap is more expensive than the previous month. Most interest rate caps are 2 years since the 3rd year is very expensive (sometimes more than years 1 and 2 combined).
      • 3rd is Strike Rate: the interest rate level, above which the interest rate cap will benefit the borrower. It is when the cap provider will begin to make payments to the cap purchaser. For example; if the Strike Rate is 3%; and the index goes to 3.5%; the interest rate cap provider will begin making payments to the cap purchaser.
    • To purchase an interest rate cap; the borrower makes a single, upfront payment to the cap provider.
  • Why do borrowers buy interest rate caps?
    • It is a set cost; paid when the cap is purchased. It allows investors to know exactly what their worst-case debt servicing scenario is during the term of the interest rate cap.
    • There are no prepayment penalties or termination costs
    • The borrower, the cap owner, still maintains exposure to the variable rate; if the index decreases; the borrower can take advantage of this.
    • It allows the borrower to fully customize their ideal mix of cost and protection.
    • It can be transferred to other floating rate debt.
    • Interest rate caps are bid out between multiple providers
  • Another option for borrowers with a variable interest rate loan is an Interest Rate Swap.
    • Just as the name states; the interest rate is swapped. The provider takes on the responsibility of making the variable rate payments while giving the borrower a fixed interest rate in exchange.
    • This tool allows the borrower to hedge rising interest rates above the fixed swap rate for a certain term. When utilizing the swap, the borrower will be able to maintain lower debt servicing payments if interest rates do in fact rise above the predetermined fixed rate. However, unlike an interest rate cap, the borrower will lose the benefit of decreasing interest rates if the rates do indeed fall after the swap is executed since the borrower will now have a fixed rate. Another downfall of the Interest Rate Swap is if the borrower decides to prepay the loan before a specific date; they could be responsible to pay an early termination fee or prepayment penalty.
  • Interest rate swaps and interest rate caps may be beneficial to borrowers if rates increase but, there is a cost to purchase swaps and caps. Certain lenders may require borrowers to purchase one of these tools in order to limit the borrower’s exposure to higher interest rates. Either way, if you are borrowing variable rate debt on a commercial property; make sure to review different cap and swap options, and don’t forget to include the cost in your underwriting.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing What is an Interest Rate Cap.

Charles:
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Charles:
During periods of rising interest rates, there are a couple tools that real estate investors can utilize to hedge the increasing debt service costs of mortgages.

Charles:
Investors who have floating rate debt, also known as a variable interest rate loans are able to employ an interest rate cap in order to set a limit, a cap on their interest rate for a set period of time. So what exactly is an interest rate cap? Well, an interest rate cap is a limit on how high an interest rate can rise on a variable rate debt. So an interest rate is essentially an insurance policy on variable rate loan interest rate caps offer borrowers protection against dramatic rate increases. So how exactly do interest rate caps work? So interest rates on commercial real estate loans are com comprised of a nominal spread with the lender charges for the risk, plus an index such as the secured overnight financing rate or so r. For variable rate loans, the spread is fixed, but the index is variable. For example, if the lender has a 3% spread and the index is 1%, the rate to the borrower is 4%.

Charles:
But if that index goes to 3%, the rate to the borrower is now 6%. If a borrower feels that rates will continue to rise during the term of their loan, they’re able to purchase an interest rate cap. So there are three main parts to an interest rate cap. First is notional, the dollar amount covered by the cap, the loan amount, also called the size of the cap. Second is term the duration of the interest rate cap, usually two or three years, typically shorter than the loan term. The longer the term, the more expensive the cap. Each additional month of a cap is more expensive than the previous month. Most interest rate caps are two years since the third year is very expensive, sometimes more than years one and two combined. Third is strike rate. The interest rate level above which the interest rate cap will benefit the borrower.

Charles:
It is when the cap provider will begin to make payments to the cap purchaser. For example, if the strike rate is 3% and the index goes to three and a half percent, the interest rate provider will begin making payments to the cap purchaser. To purchase an interest rate cap, the borrower makes a single upfront payment to the cap purchaser. So why does a borrower buy an rate cap? Well, first it is a set cost paid when the cap is purchased, it allows investors to know exactly what their worst case debt servicing scenario is. During the term of the interest rate cap, there are no prepayment penalties or termination costs. The borrower, the cap owner, still maintains exposure to the variable rate. If the index decreases, the borrower can take advantage of this. It allows the borrower to fully customize their ideal mix of cost and protection.

Charles:
It can be transferred to other floating rate debt and interest rate caps are bid out between multiple providers. Another option for borrowers with a variable interest rate loan is an interest rate swap. And just as a name states, the interest rate is swapped, the provider takes on the responsibility of making the variable rate payments while giving the borrower a fixed interest rate. In exchange, this tool allows the borrower to hedge rising interest rates above the fixed swap rate for a certain term. Now, when utilizing the swap, the borrower will be able to maintain lower debt service payments if the interest rates do in fact rise above the predetermined fixed rate. However, unlike an interest rate cap, the borrower will lose the benefit of decreasing interest rates if the rates do indeed a fall after the swap is executed. Cuz now since the borrower will have a fixed rate, another downfall of the interest rate swap is if the borrower decides to prepay the loan before specific date, they could be responsible to paying early termination fee or a prepay penalty.

Charles:
Now, as you know from my other episodes, if on fixed commercial rate mortgages, you will see that there’s usually always some sort of prepay penalty. So now that you’ve swapped out the variable debt for the fixed debt, now you’re gonna have most likely have a penalty to pay off if you want to sell a property or refinance That interest rate swaps and interest rate caps may be beneficial to borrowers if rates increase, but there is a cost of purchase to swaps and caps. Certain lenders may require borrowers to purchase one of these tools in order to limit the borrows exposure to higher interest rates. Either way, if you are borrowing variable rate dent on a commercial property, make sure to review different cap and swap options, and don’t forget to include near the cost in your underwriting. So I hope you enjoyed. Please remember, rate, review, subscribe, submit coms and potential show topics@globalinvestorspodcast.com. Look forward to two more episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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