The intrinsic value of interest rate caps

The recent and dramatic increase in the cost of interest rate caps year-to-date has, at this point, been well observed by commercial real estate (CRE) borrowers in the market for floating-rate debt. This price increase has been driven predominantly by changes in expectations of short-term rates. Interest rate caps, which reference floating-rate indices like SOFR and LIBOR, are designed to pay out if those indices cross certain thresholds (i.e., the chosen strike rate). As these indices are closely correlated with the Fed Funds Rate, the recent rate hike from the Federal Reserve along with expectations of more hikes in the future, has increased expectations for higher levels of LIBOR and SOFR, increasing the cost of interest rate caps. The graph and table below show changes in cap pricing for different structures over the past six months along with how expectations for SOFR have changed over this same period.

This pricing increase has not been well received by borrowers purchasing caps. While a year ago the cap cost was barely a rounding error on a closing statement, it has now become a more meaningful use of proceeds and a drag on underwritten returns. In some cases, it has even impacted the feasibility of deals. In this environment, we’ve had many conversations with CRE borrowers about ways to reduce cap costs and, more fundamentally, what the cost of a cap reflects.

It’s helpful to remember that the value of a cap (and other option products, for that matter) can be broken down into two components: intrinsic value and time (or option) value. The intrinsic value of a cap reflects the present value of the payments that the borrower is expected to receive on the cap, based on market expectations for where the hedged index (typically SOFR or LIBOR) will go over the life of the cap. The time (or option) value of the cap captures the possibility that market expectations may be wrong and actual rates may be higher than currently priced in, driving a higher-than-expected series of payouts on the cap. Generally, caps with lower strike rates relative to current market expectations will have premiums that are driven relatively more by intrinsic value and less by time value, while caps with higher strike rates will be driven more by time value.

Let’s put this in the context of the cap pricing changes we’ve seen recently. Six months ago, a two-year cap on SOFR for a $50M loan with a 2% strike (i.e., the cap would pay the borrower if SOFR increased above 2%) would have been ~$85K. Of that $85K, $5K would have been dealer bid-ask spread/profit and the remaining $80K was entirely time value. No portion of the cap cost was due to intrinsic value, which makes sense when you look at the forward curve for SOFR below relative to the 2% strike rate. The market was pricing-in that SOFR was not going to go much higher than 1% over the coming two years (much less the 2% required for the cap to payout). A borrower purchasing the cap knew that actual rates might go higher than what the market expected (market expectations are rarely good predictors of what will actually occur), but based on market “expectations”, the cap wasn’t going to pay out. If the borrower wanted to underwrite actual rates following the forward curve, they might reasonably conclude paying for the cap was just throwing money away, as they would not expect to ever receive a payment on the cap.

Fast forward to today and a two-year cap on SOFR for the same $50M loan and 2% strike would cost ~$893K, over ten times what it cost six months ago. Breaking this cost down as above, we’d attribute $10K to dealer bid-ask spread/profit, $222K to time value, and $661K to intrinsic value. Whereas six months ago no portion of the cost was attributable to intrinsic value, roughly three-fourths of the cost is now driven by this. The graphic below helps drive the intuition on this home. With the forward curve much higher than it was six months ago, the borrower will receive a substantial payout from the cap provider if actual rates follow the forward curve. The $661K intrinsic value represents the present value of those future expected cap payments (discounted at the SOFR curve).

Understanding this might help us look at this cap and its higher cost in a different light. If rates follow the forward curve, the borrower expects to receive back $661K of the $893K that they spent on the cap, via payments from the cap provider that would offset the interest expense on their loan. Put another way, a borrower that had the requirement for the cap waived by their lender might still expect to come out of pocket $661K of the $893K cap expense if rates simply follow the forward curve. This doesn’t change the pain of the upfront expense, but it might give the cap purchaser more comfort that the cap is worthwhile.

Please reach out to us as you’re looking to purchase interest rate caps. In addition to pricing up a cap, we’re always happy to describe in more detail how the cap cost breaks down into the different components of intrinsic and option value and give you a sense of how much you might receive in payment on the cap based on the current forward curve.