Capped Corridors

“What hedge structure’s interesting right now” is a common question. Today, capped corridors have my attention. That’s especially true for borrowers focused on the most efficient use of funds in lieu of the lowest upfront premium. Let’s dig in.

Traditional Corridor

This is a combination of two interest rate caps, one purchased (eg 3.00%) and one sold (eg 4.00%). The idea is that by selling back a higher strike, you recoup the value (volatility premium) of the 4.00% cap in exchange for protection above that level.

In other words, if SOFR exceeds 4.00% in this example, your net rate starts increasing 1-1 for each basis point SOFR is above that level.

• If SOFR resets at 4.05%, you are paying 3.05% net
• The benefit is an upfront premium that’s 20-40% lower

With the above in mind – a traditional corridor DOES NOT satisfy a lender hedge requirement since it doesn’t provide for a max all in rate. They are typically used for elective hedges and that’s why they’re popular with developers. More on hedging construction debt here.

A capped corridor is what’s needed when there’s a lender hedge requirement.

Capped Corridor

This is where you buy one more cap (two bought, one sold), and that third cap puts a hard ceiling on your rate. For instance, buy 3.00% / sell 4.00% / buy 5.00% has a net 4.00% max rate.

Here’s how the math works:

• When SOFR is below 3.00%, none of the caps come into play
• When SOFR is above 3.00% but below 4.00%, the borrower receives a reimbursement from the hedge provider for the difference between SOFR and 3.00%
  • With the capped corridor, if SOFR sets at 3.99%, borrower's net rate paid is still 3.00%
  • With the vanilla 4.00% cap, borrower’s net rate would be 3.99%, or 0.99% more
• When SOFR exceeds 4.00%, the net rate starts climbing from 3.00% to 4.00%
  • If SOFR resets at 4.25%, borrower's net rate is 3.25%
• No matter what, after SOFR exceeds 5.00%, borrower's net rate never exceeds 4.00% net
  • This is why a capped corridor satisfies a lender hedge requirement

Let’s look at pricing assuming a $50mm 2 year hedge is purchased.

A vanilla 2 year 4.00% cap costs $354k

• The market projects that cap to pay out $23k
• Therefore, if rates follow market expectations, the projected net cost of the hedge is $331k

A buy 3.00% / sell 4.00% / buy 5.00% capped corridor costs $831k

• The market projects the capped corridor to pay out $909k (not a typo)
• Therefore, if rates follow market expectations, the borrower will gain $78k under the hedge

For reference, here are the approximate market values (excluding bank adjustments) of each leg of the trade:

• 3.00% - pay $1.024mm (proj. payout $932k)
• 4.00% - receive $329k (proj. payout $23k)
• 5.00% - pay $111k (proj. payout $0)

Takeaway – you’re frontloading a lot of interest with the goal of reducing/eliminating the net cost of the cap. The capped corridor provides a lower rate paid until SOFR reaches 5.00%, provides the equivalent of a 4.00% vanilla cap (meaning it still satisfies a lender hedge requirement), and is arguably a more efficient use of funds.

The risk is that if the Fed cuts rates instead of hiking or even just holding, the net cost could potentially exceed that of the vanilla 4.00% cap. For reference:

• if the Fed doesn’t hike at all, the net cost of the capped corridor increases to $181k – still $173k below the vanilla cap
• rates would need to average <3.49% over the 2 year term for the vanilla 4.00% cap to be more beneficial

Before you write this off as “too speculative”, consider that some borrowers regularly pay up for deeply in-the-money caps (<3.00% strike today), which frontload more interest but reduce the portion of the cost attributed to volatility. If you’ve ever bought an in-the-money cap, a capped corridor has a similar risk but might be a more efficient solution.

What happens if you raise the strike?

A buy 3.50% / sell 4.00% / buy 4.50% structure results in the same max rate with a lower upfront cost ($495k).The tradeoff is a higher net cost ($73k loss) vs the lower strike strategy ($71k gain).

Using a capped corridor when all the strikes are out of the money (think 4%+) results in a higher net cost than the equivalent vanilla cap.It would only be beneficial if specific rate scenarios play out.

If you follow but would benefit from a visual, check out the interactive cashflows at the link below.

Sample hedge cashflows

Note, some lenders may push back on the strategy due to the moving parts. However, just like a vanilla cap, the structure always has a net positive MtM to the borrower, the borrower’s only obligation is the upfront premium, there’s no credit exposure to the borrower or lender, and the hedge still provides for a max rate.

Think this is strategy is worth pursuing but you haven’t worked with us before? Let’s make this the one! Give us a call at 704-887-9880, email us at pensfordteam@pensford.com, or respond directly.

Pensford has been a trusted partner of real estate investors for over 17 years. Our deep industry expertise and transparency enables our clients to make informed decisions, helping to protect their investments from market volatility and ensure stability.