I was speaking to a colleague of mine recently. Unfortunately that individual had just received the monthly financials from a syndication that they were passively invested in and was quite concerned, as the cash and cash flow were tight. In addition, the sponsor had stated that distributions were being suspended.

That particular deal, like many other deals closed in the last two-three years, was financed via a floating rate bridge loan. And while the sponsor had purchased a rate cap to partially hedge against interest rate fluctuations, such rate cap tenor was only a year (vs. the three-year loan tenor). Given the interest rate volatility, the lender had required the deal sponsor to purchase a rate cap and in the interim to start accruing for the purchase price ahead of time (below you will understand why).

While a rate cap does help mitigate against interest rate risk volatility, there are some nuances that LPs and GPs should be aware of, so they can plan ahead and avoid unpleasant surprises (like my friend).

In today’s quick snippet we will help demystify some of the interest rate hedge strategies. The article is intended to provide a high level overview. There are more technicalities within the general parameters described below and more options available that can be negotiated with a lender or a hedge provider. As such, please discuss those with your lender and cap provider. The below is not intended to offer advice or hedge strategies or to promote hedge products.

We will cover the two more common interest rate hedge tools: interest rate caps and interest rate swaps.

First, there are a couple of key concepts to understand:

The index rate or base rate. The lender would usually charge an index rate plus a spread. The most common index rate for term loans is 30-day SOFR.

The notional amount = the amount that the borrower will hedge. Usually equals the principal amount of the loan.

The tenor = indicates when the hedge matures. Usually equals the maturity date of the loan.

The strike price = applicable for rate caps and collars. Usually indicates the maximum interest rate index the loan can float to.

The higher the notional, the longer the tenor, and the lower the strike (especially in a rising rate or a more volatile rate environment), the higher the cap cost.

Interest Rate Cap

The interest rate cap limits how high the index rate can rise. As such, it allows the borrower to float the index interest rate up to a certain point (aka the ceiling).

The lender would typically specify the required cap tenor (usually aligned with the loan tenor, though there may be some flexibility in that requirement if the sponsor can demonstrate adequate reserves and/or DSC cushion to mitigate against interest rate volatility), the notional amount, the strike price, and the minimum required credit quality of the cap provider.

If market rates exceed the ceiling or cap rate, then the provider of the cap will make payments to the borrower sufficient enough to bring its rate back to the ceiling level. When rates are below the ceiling, no payments are made and the borrower pays market rates. The buyer of the cap/the borrower therefore enjoys a fixed rate when market rates are above the cap and a floating rate when interest rates are below the cap.

The lender may require the borrower to establish an escrow account with adequate reserves to demonstrate ability to pay the floating rate up to the rate cap index and until they receive reimbursement from the cap provider. In addition, if the cap tenor is shorter than the loan tenor, the lender would require such escrow to ensure the Borrower is able to pay the market floating rate post cap maturity or has sufficient liquidity to purchase a new rate cap until loan maturity. Cap rate costs have increased exponentially. Per CRE Daily, in 2020, Investors Management Group was able to purchase a 5% interest rate cap for one of its properties for $22,000. Today, a 2-year cap would cost them $1MM!!! According to Chatham Financial and CRE Daily, “in February, the price for one-year protection on a $25m loan with a 2% rate cap surged to $819,000 from $33,000 in early March 2022”!!! As interest rates fall, cap rate costs should fall as well but that is yet to be seen.

Thus, as an LP one question you can ask the operator is whether they have established adequate reserves for that (whether or not required by the lender) and how they are mitigating the floating rates on the loan in a rising interest rate environment.

Interest Rate Swap

The interest rate swap effectively fixes the index rate at a certain level. It is mostly offered by direct lenders (smaller lenders may sometimes white label a swap provided by a larger bank). This tool swaps a floating rate with a fixed rate. If the market rate is higher than the fixed swap index rate, then the swap is in the money and the lender pays the difference to the buyer. If the market rate is lower than the fixed swap rate, then the swap is out of the money and the borrower pays for the difference in index rate to keep the swap current.

Other interest rate hedge tools include:

Interest Rate Collars – caps how much the index rate can increase to and establishes an index floor it could fall to. Effectively the interest rate will float within that top and bottom band.

Forward Starting Swap – may be more applicable if the borrower wants to take advantage of lower floating rate at the beginning of the term when the borrower expects that rates will increase in the future and not in the near term. Such a swap provides more flexibility than a traditional swap and therefore may cost more.

Cancellable swaps and caps – allow you the option to cancel the hedge and similar to the above, they would typically cost more for that optionality. You may even be able to sell the interest rate cap (might make sense to sell it, only if it is in the money and we are in a declining interest rate environment). The interest rate cap option value decreases the closer the cap gets to its expiry date.

We hope today’s quick snippet was helpful and arms you with additional tools and questions to ask when evaluating hedge strategies.

Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.

Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.