The Inside Analysis on Rate Caps

Far too often, commercial real estate owners looking to hedge interest rate risk are asked to purchase derivatives and other financial products blindly. Rather than receiving transparency, borrowers are simply handed an invoice that they’re forced to pay. Unarmed to properly price hedging products and their service providers, owners overpay for many over-the-counter products.

 

A primary example is interest rate caps, a product often required on new floating rate mortgages, including bridge and construction loans. Lenders intend for their borrowers to purchase caps with minimal additional costs; yet borrowers often pay brokers exorbitant fees for even this standardized product. Although brokers should simply charge flat, minimal fees, more antiquated firms frequently charge percentage points on the loan amount even though each transaction is nearly identical.

 

For example, in the past, purchasing a $50mm rate cap would cost ~$18,500 in 3rd party fees alone. Firms such as Rate Cap Advisors have shifted the market by charging flat $5,000 fees rather than the antiquated model of charging basis points or percentages based on deal size. Like Silicon Valley startups, RCA has helped commoditize the real estate hedging field, lowering costs for borrowers and lifting the veil off a previously opaque industry.

 

 

What is a Rate Cap?

 

Rate caps are the most common method for protecting against rising interest rates. Essentially serving as an insurance policy for both the property owner and lender (i.e. it doesn’t help anyone if rates rise to 14% and the borrower defaults on their loan), rate caps ‘lock-in’ a maximum loan interest rate. Borrowers get to ‘have their cake and eat it too’ by gaining the security of a maximum interest rate while maintaining the opportunity to benefit from drops in interest rate.

 

Sample Scenario

 

Most rate caps follow identical structures: the lender dictates the deal loan amount, strike rate and term, and the cap simply needs to match these requirements. In the example below, a borrower on a $50mm loan is capping 1 Month LIBOR at 3% over the next 3 years. Any time LIBOR (London Interbank Offered Rate) exceeds 3%, the borrower will be reimbursed the difference by the bank providing the Cap.

  • Rate caps can be purchased for any length of time but are usually taken out for 2-5 years, with the average being 3.
  • Strike rates can be purchased at any level but are usually 2.5-4.5%, with the average being in the 3% range.

Rate caps effectively hedge risk for both parties – the lender and the borrower – against market fluctuations by adding a third-party to the equation. The third-party, the cap provider, guarantees that it will make any interest payments over the strike rate, protecting both sides from a catastrophic rise in rates. This allows banks to feel confident that the payments will never be missed even if interest rates skyrocket. It also allows the owner to have peace of mind knowing that he will not have to worry about paying exorbitant interest payments if rates go up.

 

 

 

 

Sample Transaction
Notional Amount $50,000,000.00
Index 1M Libor
Strike Rate 3.00%
Duration 3 Years
RCA Fee $5,000
Competitor’s Fee $18,500
Cap Premium $55,000

 

Why would you want a Rate Cap?
In most cases, new lenders require borrowers to purchase rate caps in conjunction with new floating rate mortgages. And thus, the only question becomes: How Can I Find The Lowest Possible Cost? The old system of rate cap providers hiding behind the ‘mystery’ of caps is ending and borrowers are increasingly realizing that cap costs should be minimized for the future by using more forward-thinking firms.

 

How does the economy affect Rate Caps?

 

As interest rates rise, generally Cap costs rise as well. The more likely a borrower’s strike rate to be hit, the more expensive the Cap becomes. With widespread expectations of continuing Federal Reserve rate hikes and rising interest rates in general, now more than ever borrowers are looking to purchase rate caps in order to purchase at lower costs and simultaneously protect themselves from expected market movements.

 

Ultimately, understanding rate caps and their costs is one of the most valuable tools that real estate owners can have. rate caps are the prudent and efficient way to hedge against increases in interest rates and borrowers are increasingly educating themselves about the importance of working with the most transparent providers available.

 

Company: Rate Cap Advisors

Bio for author:

Eitan Weinstock is the Senior Analyst at Rate Cap Advisors and AST Defeasance Consultants, both based in Los Angeles, CA. Eitan is recognized as an industry expert in derivatives and prepayment penalties, having closed over $10bn of transactions over the past 10 years. Eitan received his BA from Cornell University and is an active member of ICSC, NMHC, Jewish Federation of Los Angeles, and numerous philanthropic organizations.

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