With pending rate hikes, interest rate caps set to pay to CRE borrowers

It’s no secret that the Fed is likely to raise rates this week, and again in June. As this is being written, the market is pricing in a 50 bps hike this week, a possible 75 bps hike in June, and additional hikes through the end of this year and the beginning of 2023. As lending base rates tend to track the Federal Funds Rate closely, we expect LIBOR and SOFR to rise in tandem, with the market pricing in SOFR and LIBOR crossing 3.0% by the middle of next year.

One consequence of this likely increase in LIBOR and SOFR is that we’ll start to see many of the interest rate caps we have purchased on behalf of CRE borrowers start to pay out, or become “in-the-money”. If we look at the terms of the caps that we’ve purchased and track for clients, the distribution of strike rates suggests that we’ll see many caps begin to pay out in the next few months.

With these payments coming, CRE borrowers should be aware of the logistical steps that may be involved in ensuring that they receive the payments owed on their caps:

• Wiring instructions: For many of the caps we’ve purchased, borrower wiring instructions for receiving cap payments were not available upfront, meaning that dealer banks may not know where to send cap payments. It is also common for wiring instructions provided at the cap purchase to be outdated and incorrect. Cap purchasers should review their trade documentation to see if the wiring instructions were provided to the cap provider and if they are still accurate. If not, they should reach out to the cap provider to furnish accurate instructions.
  
  
• Lender involvement: Most interest rate caps that we arrange are purchased to satisfy lender requirements, with the caps assigned to the lender, and the lender specifying the wiring instructions for any payments received on the cap. In these situations, cap purchasers will need to coordinate with their lender to confirm the appropriate wiring instructions before providing them to the cap seller.
  
  
• Application of payments: If a cap is lender-required and pays into a lender-controlled account, there are two different ways a borrower may receive the benefit of this payment. Some lenders/servicers may deduct the cap payment directly from the current interest payment statement, leaving the borrower with an interest payment that is net of any payment the lender receives on the cap. Other lenders/servicers may invoice the borrower the full interest expense for a given period without the benefit of the cap, and then reimburse them for the cap payment separately (perhaps in the next month’s interest statement). In speaking with a few lenders/servicers anecdotally, many may prefer the latter approach, but we’ve spoken to enough others to know that there is still uncertainty in some cases as to how this may work. The choice of one approach over the other won’t ultimately impact the net interest payment made by the borrower, but it would affect the timing of cashflows, and some borrowers may prefer to be aware of this.
  

In the coming weeks, we’ll be reaching out to clients with caps that may start to pay out to ensure that they’re set up to receive those payments in a timely and accurate manner. Nevertheless, please don’t hesitate to reach out to us with any questions that you might have.