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 requiring 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 4.00% strike.
Does structuring it this way help on the cost?
Definitely. Cap costs are primarily driven by two things, (i) the intrinsic value, and (ii) time/volatility.
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 accreting cap could be less than half the cost.
At almost $255k a 4.00% cap is hardly cheap, but in a higher for longer scenario, the cap protects at a level below current SOFR. However, unlike lower strikes, if the Fed cuts faster than expected, interest wasn’t frontloaded that otherwise wouldn’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.
What about floors?
If your lender has a higher index floor and you’d like to obtain the ability to float below it, a floor (derivative) can be purchased to offset what’s in the loan agreement. Floors are similar to caps but in lieu of paying out when SOFR goes above the strike, floors pay out when SOFR goes below the strike.
For instance, if your lender’s index floor is at 3.50%, the purchase of a 3.50% strike floor would completely offset what’s in the loan. If SOFR goes below 3.50%, a reimbursement would be received for the difference between 3.50% and SOFR.
Below, we’ve included the cost to purchase a floor based on the same draw schedule.
If there were no draw schedule, here’s what pricing would look like.
Another option is to execute a floor spread, which simply lowers the index floor rather than completely negating it. Floor spreads are also cheaper than vanilla floors. For pricing on this option, contact us.
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:
Disadvantages of caps include:
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.