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Market Update

Hedge pricing is up, and so are cap values

Date:
January 25, 2022

Summary

Several colleagues and I attended the 2022 NMHC (National Multifamily Housing Council) Annual Meeting in Orlando last week and, as always, it was a great conference. Attendance was strong and we were able to connect with many clients and other industry partners to get their read on the multifamily space at the onset of the new year. The mood was generally positive. There’s some concern about asset prices and what that means for the ability to find deals, and how deals might pencil if interest rates rise and loan coupons/spreads widen out. That said, everyone with whom we spoke seemed optimistic that we’d have another good year in 2022.

As you might expect, we spent a lot of time talking to our clients about the outlook for interest rates and costs associated with interest rate hedging. Some themes emerged from those conversations, and we thought we’d summarize those here for our broader client base.

Hedge pricing is up….

Many of our clients that operate in the multifamily space use floating-rate debt. It’s the natural choice for transitional assets and increasingly appealing on any deal where pushing leverage is needed to make underwriting work. Those loans – whether Agency debt or loans from debt funds – almost always require an interest rate cap to allow the lender to underwrite to a worst-case interest expense. With the recent move up on the short end of the curve (the market is pricing in around four rate hikes from the Fed this year and two-to-three more in 2023), pricing for these products has unfortunately increased significantly. Many of our clients have been watching this happen in real time as they’ve seen costs go up on each successive deal. It can be shocking for those investors that may not have hedged recently. I spoke with a client who had been a seller in 2021, and is just now pivoting back to acquisitions. She was stunned when I showed her where pricing is today relative to 12 months ago.

SOFR forward curves based on NY Fed 30-Day SOFR

SOFR interest rate cap pricing, $50M loan amount (today vs. 12 months ago)

…and borrowers and lenders are finding creative ways to manage those costs…

In the context of these higher costs, borrowers and lenders are trying to get creative to manage them and help deals pencil. We’re seeing many debt fund/non-bank lenders agree to require caps of only two years (rather than three) and we’ve heard Freddie Mac may selectively permit this, subject to credit approval and a mark-up in the loan spread. We’ve seen other lenders permit “springing caps”, where the cap isn’t required upfront at all, but only if SOFR crosses a specific threshold. These can be great ways to structure to a lower upfront cost, but we encourage borrowers to think about the risk/reward trade-offs of these approaches. These upfront savings may be more than offset over time if rates increase more quickly than priced into the market, making cap extensions or springing caps more expensive. As surprising as the market-implied speed of rate hikes might seem, the Fed dot plot suggests an even more dramatic increase is possible.

SOFR forward curve vs. Fed expectations

….and forgetting that their existing caps may be worth more than what they paid.

Given the falling short-term rate environment we’ve had the past few years, many of our clients have become conditioned to the caps they buy gradually (or quickly) losing value as they get close to maturity and having no residual value when the loan gets paid off. With the increase in short-term rates, that’s now not always the case. We've recently helped a number of clients sell a cap for more than they paid for it. In one example, we helped a client purchase a cap for ~$350K this past May in conjunction with a new loan. At the end of the year, they unexpectedly found themselves refinancing the asset. They no longer needed the original cap and were surprised to hear that it had gone up in value as short-term rates rose. We helped them sell it back to the market for ~$600K, a profit of over 70%. While it’s often difficult to sell a cap prior to a loan maturity/pay-off – lenders need the cap in place and usually have consent rights to a sale – borrowers that are paying off loans with caps should reach out to Chatham to see if there’s residual value they can recoup.

Want to price up a cap or see if your current cap has residual value?

Contact a Chatham expert


Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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