Hedge pricing is up, and so are cap values

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.

…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.

….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.