Interest Rate Caps Simply Explained

An interest rate cap is essentially an insurance policy on a floating interest rate loan.

This caps/limits the maximum interest expense exposure for a borrower using a floating-rate loan. Lenders also benefit as they can require an interest rate cap at a rate threshold that helps ensure the borrower can service interest payments comfortably, limiting the risk of non-payment in a rising interest rate environment.

Floating interest rate debt has 2 components:

  • Benchmark Index
  • Spread

A common benchmark index is SOFR but can include the U.S. Treasury rate, the Federal Reserve funds rate, or the prime rate. The spread is the interest the lender is charging you and how they make a return on their capital. Riskier, more speculative real estate loans tend to have higher spreads (to compensate for additional risk).

Benchmark Index + Spread = Total Interest Rate


Buying Interest Rate Caps

The rate cap is usually purchased upfront and can often be financed in a development project or heavy renovation business plan (negotiable with the lender). 

The cost of the cap will generally depend on a few factors:

  • Notional – The notional is the size of the cap. This will usually match the total loan amount—the higher the loan, the more costly the rate cap.
  • Term – The term of the cap is the length of time that the cap is protecting the borrower. The longer the duration, the more expensive the rate cap. Lenders may require the term of the cap to be the same length as the loan.
  • 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. So lower strike caps are more expensive than higher strike caps.

Interest rate and market volatility also has a dramatic impact on rate cap pricing, which changes daily. To receive the most accurate rate cap pricing, visit Chatham Financial and use their rate cap cost calculator.

Rate Cap Calculator


Underwriting Interest Rate Caps

Your underwriting model should have a fixed and floating interest rate capability.

If your underwriting model does not have a floating interest rate feature, I would recommend you underwrite to the highest rate possible with your loan (the loan interest rate at the maximum (capped) interest rate).

Example: You buy an interest rate cap and you know the maximum rate you will ever pay is 8%. Run the analysis off of the 8% fixed rate.

Ideally, you want to use a model that has floating interest capability and a feature where you can choose how long the rate cap is in effect for. The Next Level Value-Add Model includes this feature.

We can choose the option to have a fixed or floating interest rate, interest rate floor, and how long both will be in effect for so that we have the most accurate analysis possible. Let me know if you have any interest in using this model once complete!

Conclusion:

Interest rate caps have become very mainstream in the last few years as interest rates have increased. The truth is, interest rate caps were relevant 10 years ago and will be 10 years from now. They can be used anytime a borrower wants to hedge their risk when using floating rate debt.

Ultimately, a deal is not automatically good or bad if the borrower chooses to use floating rate or fixed interest rate debt. Same goes for choosing to purchase an interest rate cap on the deal. It all comes down to the level of risk the borrower (and their investors) are comfortable with.