What is an interest rate cap?
SummaryAn interest rate cap is essentially an insurance policy on a floating rate, most frequently 1-month LIBOR. It has three primary economic terms: notional, term, and strike rate.
An interest rate cap has three primary economic terms: the loan amount covered by the cap (the notional), the duration of the cap (the term), and the level of rates (the strike rate) above which the cap will pay out. As an example, a $100M, 3-year, 4% strike cap will pay out if LIBOR exceeds 4% over the next 3 years. This puts a ceiling on the purchaser’s all-in loan coupon of 4% plus their loan spread.
Caps are typically purchased upfront with a single premium payment and can be terminated at no cost by the cap purchaser. With a known upfront payment and no prepayment penalty, caps are a commonly used interest rate hedge by borrowers, particularly for shorter term debt on transitional assets that require flexibility for a refinance or sale. As caps permit an investment to be underwritten to a worst-case interest expense, floating-rate lenders commonly require their purchase as a condition to closing a loan.
What determines the cost of an interest rate cap?
For a given interest rate environment, cap pricing is driven by three variables:
- Notional: The notional is the “size” of the cap — the amount of loan it is hedging. Generally, a cap with a larger notional is more expensive than one with a smaller notional. Cap pricing tends to change linearly with notional (i.e., a $100M cap will be roughly twice the cost of a $50M cap). This relationship may not hold true for caps on either extreme (very small or very large loan amounts) or for caps that are relatively inexpensive.
- Term: The term of the cap describes the length of time that the cap is protecting the borrower. The longer the term, the more expensive the cap. Generally, each additional month of the cap term is more expensive than the previous month; pricing does not increase linearly with term. For example, the third year of a cap is often materially more expensive than the first two combined.
- Strike rate: The strike rate defines the interest rate at which the cap provider begins to make payments to the cap purchaser. The lower the strike rate, the more likely that a cap provider will need to make a payment during the term of the cap. Consequently, lower strike caps are more expensive than higher strike caps.
For a given cap structure (i.e., notional, term, and strike rate), cap pricing will fluctuate over time based on changes in:
- Key rate: The key rate for a cap is LIBOR’s market-implied expectation over the term of the cap. A 3% key rate suggests an expectation that LIBOR will average 3% over the cap term. As the key rate increases, the likelihood of a payout to the cap purchaser increases, which will drive an increase in the cap cost. Conversely, a decline in the key rate will result in a decline in the cap cost. The market swap rate for a given term approximates the key rate for the same cap term (i.e., a 3-year cap will be sensitive to movements in 3-year rates). Access current market swap rates at ChathamRates.
- Interest rate volatility: Interest rate volatility reflects the market’s confidence that actual LIBOR resets over the cap term will match those implied by the key rate. Higher interest rate volatility implies a greater likelihood that rates will spike higher than the key rate, which would result in a larger payout by the cap seller. Consequently, as interest rate volatility increases, cap pricing will also increase.
Lender documentation requirements may also impact cap pricing, and borrowers may be able to reduce cap costs by negotiating these requirements and the cap economics as follows:
- Lender strike rate requirements: If a lender is requiring a cap, they will often specify the strike rate for the cap, which is usually derived by solving for a minimum DSCR (debt-service coverage ratio) based on lender underwritten NOI (net operating income). Some lenders will have flexibility to adjust this strike rate, either for the entire term of the cap or in the latter years of the cap in conjunction with underwritten NOI growth. A structure with a strike rate that increases over time is known as a “step-up” strike and is often an effective way to reduce the cost of the cap.
- Lender term requirements: Lenders will often require a cap, structured to be coterminous with the initial term of the underlying loan. This can be problematic in loans with terms of three to five years as caps of these tenors are often expensive. Lenders may agree to an initial cap term that is less than the initial term of the loan. Or a borrower and lender will agree to reduce the initial term of the loan to help reduce the cap cost (i.e., adjusting the loan from 3+1+1 to a 2+1+1+1 structure).
- Credit rating provisions: Most lenders that require caps mandate that the cap provider have a minimum credit rating (usually from S&P, Moody’s, and/or Fitch) at the time of the cap purchase, and further mandate that a downgrade below a defined threshold after purchase be cured via the purchase of a new cap (a provision known as a “downgrade trigger”). Caps are documented to pass the risk of a downgrade trigger from the cap purchaser to the cap seller. This reduces the risk to the borrower but can impact the cost of the cap to a greater or lesser extent depending on how that language is written. It’s important to understand the impact of any such language, and the borrower should consider approaching the lender about adjusting it if the language has a material impact on the cost. Different lenders may have varying degrees of flexibility on these terms depending on their underwriting standards.
- LIBOR rounding: LIBOR is quoted to five decimal places, but some loans may require that LIBOR be rounded to four or three decimal places. If the cap is structured to match this rounding precisely, it may slightly increase the cap cost. Such rounding language is regularly negotiable and often removed at the request of the cap purchaser/borrower.
How long does it take to purchase a cap?
Evaluating and executing on a cap purchase involves multiple steps. While Chatham can often purchase a cap on as little as 24 hours’ notice, we recommend engaging with us two weeks prior to a planned purchase. This provides sufficient time for Chatham to thoroughly review the cap terms and to identify and onboard with the most price competitive and creditworthy cap providers.
What documentation is required to purchase a cap?
Purchasing a cap requires documentation at several points along the process:
- Cap provider onboarding: The mortgage borrower entities that often purchase caps rarely have pre-existing trading lines with the major cap seller banks. To onboard these entities, cap sellers will need to obtain “Know Your Customer” (KYC) information from them. This KYC information is used to run background checks on the borrower, its major investors and officers, and establish that the borrower is duly formed. KYC includes tax forms, formation documents, information on the borrower’s ownership structure, and in some cases, information on individual investors. Regulators require that cap provider banks obtain this information prior to a cap purchase.
- Regulatory compliance: Prior to the purchase of a cap, regulatory compliance documents must be completed and signed by the cap purchaser so that they and the cap seller comply with the relevant regulatory statutes. Though signed and delivered before the cap purchase, the documents do not create any obligations on the part of the cap purchaser until after the cap purchase.
- Chatham transaction summary: Immediately after the purchase of a cap, Chatham will provide a transaction summary on Chatham letterhead confirming the purchase and its material economic terms. Lenders rely on this as evidence of the purchase while the trade confirmation is prepared.
- Trade confirmation: The trade confirmation is the interest rate cap agreement. It is produced by the cap seller after completion of the purchase, and spells out the economic and legal provisions of the cap. It is circulated within one–two days of the cap purchase and signed by the cap seller and cap purchaser.
- Incumbency certificate: When executing the trade confirmation, the cap purchaser must also provide an incumbency certificate, corporation resolutions, or similar authorization forms that attest to the signatory’s ability to execute the trade confirmation, and confirms the authority of the purchaser to enter into the cap. Chatham drafts the incumbency certificate on behalf of our clients.
- Collateral assignment: If a cap is purchased as a lender requirement for a loan, the borrower usually needs to assign their interest in the cap to the lender for the duration of the loan. This assignment is accomplished via a “Collateral Assignment of Rate Cap” (or similarly named) document, which is signed or acknowledged by the lender, borrower, and the cap seller. It is drafted by the lender’s counsel, reviewed by potential cap sellers prior to the cap purchase, and delivered to lender’s counsel immediately after the cap purchase.
- Legal opinion: Some lenders require a legal opinion from the cap seller (from either the seller’s internal or external counsel) that attests to the cap seller’s good standing, due authorization to provide an interest rate cap, and the enforceability of the cap provisions under New York law. The opinion is circulated one to two weeks after return of the fully executed trade confirmation to the cap provider.
Why work with Chatham?
We have three goals when placing interest rate caps for our clients. First, we want them to feel comfortable handing over the entire process to us knowing that we’ll have the cap in place in time for loan closing. Second, we want them to get the best possible price. Third, we want them to know we’ll support them for the entire duration of the cap term.
Chatham places in excess of 4,000 caps annually. We leverage our volume and breadth of experience, working with every lender in the market, and understand how to run the process from start to finish so that your lender gets exactly what they need at the time of loan closing. We use our insight to find where your lender may have flexibility on structure or requirements that could reduce your cost. Our volume levels the playing field for you and allows us to find the most competitive pricing from cap providers.
After your cap is purchased, we remain your partner for the life of the trade. Our consultants are always available to answer questions, whether you want to know how to sell the cap back if you’re paying off a loan early, or if your auditor has a question on the cap valuation for financial statements. We also provide you access to ChathamDirect, our client portal, where you can view your cap documentation, check to see if you are due any payments on the cap, and download daily cap valuations.
Ready to execute an interest rate cap?
Schedule a call with one of our advisors.
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.20-0056
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