“Springing” interest rate cap requirements in CRE loans
Hedging and Capital Markets
Real Estate | Kennett Square, PA
“Springing” interest rate caps are a type of loan requirement that requires a CRE borrower to purchase an interest rate cap post loan closing if (and only if) the base rate for a floating-rate loan (like SOFR) crosses a certain threshold (often called the “trigger”). This structure permits the borrower to defer (and possibly avoid) the expense of an interest rate cap at the risk of a higher cost if rates rise sooner and more than expected. With rising rates and cap costs, we expect such provisions to be triggered in existing loans and included in more new loan originations. This article provides an overview of how a CRE borrower should weigh the potential risks and benefits of such structures.
- A springing interest rate cap is a loan requirement which requires a borrower to purchase a cap if the index rate for the loan crosses a predetermined threshold.
- Springing caps allow a borrower to avoid the cap’s upfront cost at the time of loan closing. Over the life of the loan, the borrower may avoid the cost entirely if rates remain low or pay significantly more if rates rise sufficiently.
- With short-term rates rising, we expect these provisions in many loans to be triggered, requiring borrowers to purchase an interest rate cap. We expect to see them viewed more frequently in new loan originations as borrowers try to reduce hedging costs.
- Borrowers evaluating such a provision in a new loan origination should consider their view of the current forward curve, their expectations for paying off/refinancing the underlying debt, and their tolerance for risk and uncertainty in potential costs.
- Chatham can assist borrowers in reviewing their existing loan portfolios for the presence of springing cap requirements and whether such caps should be purchased in advance of being required.
What is an interest rate cap?
An interest rate cap is essentially an insurance policy on a floating rate, most frequently SOFR. It has three primary economic terms: notional, term, and strike rate.
The immediate benefit of such a structure is that the borrower avoids the upfront cost of the cap. Over the loan’s term, they may avoid the cost entirely if rates don’t cross the threshold triggering the purchase, or they may find that the cost of the cap is less than if they had purchased it upfront if rates do cross this threshold but no faster than originally expected at the time of the loan close. Conversely, if rates rise more quickly and/or more significantly, the cap requirement may be triggered and cost more than if the borrower had just purchased the cap at closing. This approach will often appeal to borrowers that hope to sell/refi the underlying asset well before the loan maturity or to borrowers that are simply willing to take the view that rates will be lower for longer than the forward curve prevailing at the time of the loan close.
With the recent rate hikes from the Fed and expectations for additional hikes this year and next, this structure has recently come up frequently in our client conversations, primarily in two contexts. First, many clients have reached out to help them evaluate their existing loan portfolios to understand if they have any loans with these provisions and, if so, what their requirements are. Through these conversations we have reviewed over 11,400 floating-rate loans, identifying over 650 loans with such requirements, spread across 100 distinct lenders. As the histogram below shows, many of these requirements have been triggered over the last several months as base rates like SOFR have increased.
Bars show the number of loans we identified in our database with springing cap provisions tied to index rates reaching the trigger ranges. The date on each bar shows the month that index rates (1-month LIBOR and 1-month Term SOFR) are expected to cross the lower end of the range shown.
In both of these contexts, a common conversation theme has been the timing for purchasing springing caps – should a borrower purchase a cap now to “get ahead” of a purchase requirement that may be triggered in the future (thus locking in a known cost today), wait to purchase the cap only if and when it’s required, or defer and re-evaluate the purchase at some future date. This is always a tough question to answer. At its root, this is a question of where rates will go and what cap prices in the future will be relative to cap prices today, neither of which are easily predicted. That being said, understanding some key concepts and considerations can give a borrower a better framework for considering springing caps:
Forward curve: A starting point for evaluating whether a borrower should “get ahead” of a springing cap requirement should be the current forward curve for SOFR/LIBOR. While the forward curve has historically been a poor predictor of rates, there’s some argument to be made that the front of the curve may be more predictive given how deliberate the Fed has been in telegraphing its policy decisions. As of October 7, 2022, the current forward curve shows 1-month Term SOFR hitting ~4.25% January of 2023 and peaking at ~4.40% in March 2023. A borrower with a “springing cap” triggered when SOFR hits 4.00% might be more inclined to purchase the required cap today, understanding that the market is projecting it may be required in a few months anyway. Conversely, a borrower with a cap triggered when SOFR hits 4.00% may be more inclined to wait and hope the trigger never materializes.
Borrower view of forward curve: Generally, so long as rates follow or undershoot the path implied by the forward curve any deferral of a cap purchase will make sense in hindsight. Similarly, a deferral may look like a bad idea in hindsight if actual rates exceed the path projected by the forward curve. With this in mind, a borrower that wants to take the view that rates are more likely to exceed the forward curve would be more likely to purchase a springing cap early and, conversely, a borrower more inclined to take the “under” on the forward curve should be more inclined to wait.
Interest rate volatility: It’s intuitive that the term and strike rate of a cap, along with the market’s implied expectations for future rates, can impact cap pricing. A less intuitive, but often just as significant, factor of pricing is interest rate volatility. This measure reflects the market-implied probability and the extent to which actual rates may deviate from the forward curve in a way that drives larger than anticipated payouts from the cap provider to the borrower. While it’s impossible to predict how volatility will change over time, the impact of volatility on a particular cap structure can be quantified. In this way, a borrower can gain an understanding of the magnitude of pricing risk that this factor introduces to a borrower considering deferring a cap purchase to meet a springing cap requirement in a loan.
Sensitivity of cap pricing: Cap pricing is sensitive to a variety of factors, including movements in interest rates, interest rate volatility, and the cap’s term. While we can’t predict how pricing will evolve over time, we can put numbers on how sensitive a cap’s pricing is to these different factors, and which factor plays a more pronounced role on a relative basis. For example, a 3-year, $50M cap with a 4.50% strike on 1-month Term SOFR would cost ~$945K today, with that value declining by ~$31.5K for every month of term that “burns off”, increasing by ~$5.6K for every 1 basis point move in 3-year rates, and increasing by $31.4K for every 1% movement in rate volatility. A borrower that is informed of these numbers will have better intuition on how the cap pricing might change over time and will be able to better evaluate the potential benefits of purchasing a cap now vs. waiting until later.
Asset strategy: As with all hedging decisions, the approach a borrower takes to a springing cap should be informed by the business plan for the underlying asset. A shorter hold period or window of refinance for the underlying asset should, all else equal, make a borrower more inclined to defer a springing cap purchase as long as possible, and vice versa if there is a longer anticipated hold period or window of refinance.
Lender flexibility: Irrespective of the loan language regarding a springing cap, a lender may be willing to waive or modify these requirements. We’ve seen several instances where our clients have been able to negotiate adjustments to these provisions with their lenders. It's worth clarifying, though, that lenders tend to view these situations on a case-by-case basis, factoring in heavily the underlying asset performance and their relationship with the sponsor. We’ve not seen any lenders agree to modifications on a programmatic basis.
Sensitivity analysis: As mentioned above, trying to predict future cap costs is a dubious exercise. That being said, we do think sensitivity analysis on what a cap cost might be in the future based on different rate environments can be a helpful exercise for a borrower to establish bookends around the range of likely outcomes and better quantifying the risk of deferring a cap purchase until later.
We hope this overview has been helpful. Please feel free to reach out to us if you’d like us to review your portfolio of loans to identify any springing hedge requirements. Also, feel free to reach out if you’d like us to help you think through how to handle a specific springing cap situation, whether that is to better understand when that requirement may be triggered or for a more thorough analysis around purchasing the cap now vs. waiting until later.
Need help with understanding your springing cap exposure?
Contact Chatham to review your loan portfolio for springing cap requirements.
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.22-0156
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