There are numerous ways to manage interest rate risk, but interest rate caps are one of the most straight forward and flexible options. A cap is a ceiling on a floating rate index such as SOFR. The borrower pays an upfront premium to buy what is essentially an insurance contract on floating rates for the term of the hedge.
Caps are often used to hedge construction loans since they retain the ability to float lower, put a hard ceiling on rates, and have no potential prepayment penalty. Many construction lenders are even starting to require them! In this resource we’ll answer some of the frequently asked questions related to hedging construction loans.
I put my equity in before drawing on the loan. How does that work with a cap?
Caps are flexible instruments that can easily be structured to align with the underlying financing. If you close on the loan today but don’t begin drawing for a year, the cap would be structured to become effective in a year. We call this a forward starting cap.
What about the draw schedule? How do I avoid being over hedged?
Similar to the previous answer, caps are flexible and can be structured around the draw schedule. Each month of cap protection is based on a predetermined notional (aka the amount hedged) and strike, both of which can be increased/decreased over time.
Let’s assume you have a 3 year $50mm construction loan but don’t make the first draw until month 13. The cap would be structured to begin on month 13 (with the first anticipated draw being the notional amount for that period) and stepping up based on the pre-determined draw schedule thereafter.
Below’s a sample of how this cap might be structured with a 5.00% strike.
I’m hearing caps are expensive. Does structuring it this way help on the cost?
Definitely. Cap costs are largely driven by two things, (i) the intrinsic value, and (ii) time/volatility.
- The intrinsic value is better known as the projected payout, which is a result of the cap strike being below the forward curve (making that period in-the-money “ITM”) at the time of purchase. This is the main driver of the difference.
- Since the curve is inverted today and the cap doesn’t start for a year, a 5.00% strike isn’t projected to ever be ITM.
- Even if the cap were ITM (eg with a 4.00% strike), you’re only hedging ~$4.2mm the first period in lieu of the full $50mm. The first month would still be ~92% cheaper than if the full amount were hedged.
- The time/volatility component is more noticeable in the tail months of a longer term (eg comparing a 2 year to a 3 year), since each additional year of term adds to the uncertainty, increasing the cost exponentially. Skipping the first year only has a minor effect on the cost.
Below we’ve outlined current pricing to help illustrate the impact. The first table is our hypothetical 1 year forward starting cap based on a draw schedule.
The next table is a spot starting (effective today) cap with no draw schedule.
Depending on the structure, the construction cap could be less than half the cost.
At almost $300k a 5.00% cap is hardly cheap, but in a higher for longer scenario, the cap protects at a level below current SOFR. However, unlike the lower strikes, if the Fed cuts as expected (or even faster), interest wasn’t frontloaded that otherwise won’t be recouped.
One creative option we’ve seen on loans with high SOFR floors is setting the cap strike to match the index floor on the loan. This results in a synthetically fixed rate for the term of the hedge.
What happens if I prepay before the cap maturity?
After paying the premium, the cap is nothing but an asset to you that can never be worth less than $0. In other words, there’s no potential liability when you pay off the loan in the future.
The cap could be assigned to another financing, held in the portfolio as a general hedge, or unwound and the residual value recouped. The residual value is a product of remaining term and market rate expectations at that time.
When do people buy them?
Some borrowers prefer (or are required) to execute the cap at closing to remove rate risk at a known cost. At that point the draw schedule and timing are still a best guess, but that just means being slightly over/under hedged until reaching the full funding point.
Others budget for and buy a cap in the future when the first draw is made on the loan. This provides more certainty around the timing of draws but exposes borrowers to changing hedging costs in the interim. In some cases, allowing time to pass decreases the cost of the cap (all else equal), but if rate expectations rise, the budget might allow for less protection than could’ve been obtained at closing.
Is there anything else worth knowing about capping construction debt?
Here’s a list of the advantages/disadvantages of interest rate caps.
Advantages of caps include:
- Known upfront cost
- No prepayment penalty
- Can be bid out to obtain lowest cost and best terms
- Retain exposure to floating rates
- An asset that can be sold to recoup any remaining residual value
Disadvantages of caps include:
- Upfront cost can be high – especially on longer terms and lower strikes
- Costs can change quickly
Conclusion
Many developers are interested in ways to mitigate interest rate risk and caps are often at the top of the list. Structuring the cap around the anticipated draw schedule through a future anticipated sale/refi date helps mitigate the risk of a cost overrun in an efficient manner. Stay tuned for our next resource in a series related to hedging construction loans.
Pensford has been a trusted partner of real estate investors for over 15 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.
If you’re a real estate developer or investor, we’re here to help. Please reach out to 704-887-9880 or contact pensfordteam@pensford.com to learn more.
