Many developers are interested in ways to mitigate interest rate risk and caps are often at the top of the list. Structuring a cap around the draw schedule through a future anticipated sale/refi date is a common strategy, but the upfront cost often leads borrowers to seek out other options. Collars are up next in our series related to hedging construction loans. If you missed our previous blast on caps, check it out here first.
An alternative to a vanilla cap is a collar. A collar is a combination of (i) a cap that is purchased, and (ii) a floor that is sold, both with the same bank. Many borrowers aim to execute a “costless collar” where the value of the cap purchased equals the value of the floor sold, resulting in a net $0 cost.
In general, the benefit of this structure is there’s no cost to the borrower, but the downside is the sale of the floor creates a liability and limits the ability to float lower if/when the Fed cuts. More high-level details on collars here.
A quick note about feasibility of collars.
The sale of a floor creates a liability to the borrower (and asset to the bank), resulting in credit exposure that the bank must secure. If the hedge provider is also your lender, the underlying real estate securing the debt will typically be used to secure the hedge as well.
If the lender is not a bank with the ability to offer hedges, the hedge provider would need to be a third party who would likely require cash or other securities to be posted to secure the exposure. Therefore, collars are uncommon when borrowing from a non-bank lender.
Since the collar is just a combination of a cap and floor, could it also be structured to have a future start date and match my draw schedule?
That’s exactly right, caps and floors are structured the same. One just pays out when rates rise above the strike and the other when rates go below it.
How does pricing look on a costless collar for a construction loan today?
Below we’ve outlined current pricing taking into account the forward start and draw schedule of our hypothetical loan.
By way of example, borrower could purchase a 5.00% cap, but in lieu of paying $295k, a floor with a 3.76% strike could be “sold” to offset the upfront cost. Raising the strike lowers the floor (and vice versa). However, since the 4.00% strike is below the swap rate for the equivalent structure, a costless collar would not make sense for that one.
What would the pricing be without the forward start and draw schedule?
It’s certainly much less attractive, see below. This is the reason we rarely see collars used for anything other than construction loans.
You said the cap has no potential prepayment penalty. What about a collar?
This is one of the big downfalls to a collar – you’re effectively trading a known (the cap premium) for an unknown (the floor liability). If you sell/refi early and rates have fallen, the value of the floor has likely increased (and the cap decreased), meaning that there’s now a breakage to get out of the trade.
While collar breakages may only be 50-75% of the equivalent swap breakage, that could still be a material penalty if rates fall enough. Below we’ve included a table outlining rough collar breakages assuming the buy 5.00% / sell 3.76% structure above is executed.
Some notes on how to interpret the table above:
- The gray “Market Proj.” column outlines the projected breakage if rates follow the current forward curve. Day one the collar is against you by the amount of the credit charge ($124k in this scenario).
- Rates are projected to fall due to the inverted curve, so 2 years from now (June 2026), markets
project 1 year rates (matching the remaining term) to be 4.05%. While the 3.76% floor isn’t projected to come into play, the collar would still represent a ~$63k liability. - Building off the above, if rates are 100 bps below current projections (implying a 3.05% 1 year swap rate), the breakage would be ~$367k. Conversely, if rates are 100 bps above expectation (5.05%), the collar would be a ~$91k asset.
Any other risks worth highlighting?
Does your loan have an index floor too? We’ve seen SOFR floors as high as 4% this year. If your loan has one, that presents an issue. Assume you execute the buy 5.00% / sell 3.76% collar and your loan has a 4.00% index floor.
- When SOFR is >5.00%, the cap is providing a reimbursement, and your net rate is 5.00%.
- When SOFR is between 5.00% and 4.00%, you just pay SOFR.
- When SOFR is below 4.00% but above 3.76%, you pay 4.00% SOFR on the loan, but nothing is owed under the hedge. The net rate is 4.00%.
- When SOFR goes below 3.76%, you pay 4.00% SOFR on the loan, but the difference between 3.76% and SOFR is also owed on the hedge.
- If SOFR went to 2.00%, the net rate for the period would be 5.76% (4.00% loan + 1.76% hedge). If SOFR went to 0.00%, the net rate increases to 7.76% - not good!
As outlined above, if your loan has a floor and you sell one on the hedge side too, then you could find yourself paying an even higher rate in the future if SOFR goes below both floors. For this reason, collars should be carefully considered for loans with an index floor.
Why might someone consider a collar on a development deal over a cap or other option with more flexibility?
In the past, clients have highlighted one or more of the following points as reasons they preferred the collar over the cap.
- Managing costs is important and the collar has no upfront cost.
- It puts a ceiling on rates, protecting against an unforeseen tightening cycle.
- Their budget is based on the forward curve at closing, and if they’re paying interest at the floor, then they’re still under budget.
- Having a cap helps reduce the interest reserve they’re required to set aside at closing.
- A sale before stabilization is unlikely so they’re not concerned about paying a breakage.
- A common strategy is to hedge through stabilization (or just slightly beyond) to minimize any potential early breakage penalty.
Conclusion
Many developers are interested in ways to mitigate interest rate risk and collars are another viable option. Structuring the cap/floor around the anticipated draw schedule and sale/refi date can often result in a reasonable cap/floor. This provides certainty for the budget while balancing the risk of a penalty due to early prepayment. 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.
