A growing number of commercial real estate sponsors are buying in-the-money interest rate caps to hedge new short-term floating-rate loans, a strategy they believe will allow them to mitigate the impact of higher rates.
Sponsors seeking to refinance existing, more highly leveraged debt in the US and the eurozone are the primary buyers, and market participants who spoke with Real Estate Capital USA reported an increase in usage over the previous three to four weeks. The hope is that by the time the loan matures, the borrower will be refinancing into a lower-rate environment, they added.
Interest rate caps function as insurance policies that will pay out if the rate on a loan rises above a certain level. They are typically purchased by a borrower – in this case, a commercial real estate sponsor – at the outset of a loan. At the time of purchase, the sponsor and the provider will negotiate the strike price, or where the rate of the loan needs to be for the cap to pay out. The sponsor will then make a single, premium payment which covers the entire cost of the cap.
“I think we have been in a little bit of suspended reality in our industry. A lot of what is going on is about buying time, not solving a long-term problem”
Taurus Investment Holdings
However, as sponsors contend with more expensive loans, some are willing to pay large upfront premiums to acquire caps with a strike price below today’s rates, to benefit from them immediately.
A borrower today that is, for example, looking at a new floating-rate loan with a rate of 6-7 percent can buy an in-the-money cap with a 3 percent strike price. Because rates today are higher than 3 percent, the cap provider will immediately begin making payments back to the borrower on the cap.
“Borrowers immediately benefit from the cap, and over the life of the loan, can recoup a significant amount of the cost,” said Dan Lisser, a managing director at New York-based advisory Marcus & Millichap. “In a borrower’s view, they are basically pre-paying the interest.”
Buying an in-the-money cap can also help a borrower that is working to refinance or extend an existing loan but does not want to make a significant equity contribution to ensure the loan stays within the lender’s interest coverage ratio covenants, market participants said.
Joe Iacono, chief executive of New York-based alternative lender Crescit Capital Strategies, noted that while in-the-money caps can be used to mitigate the amount of interest reserve required or to help meet debt service coverage ratio requirements, there are several factors to consider.
“The premium for an in-the-money cap can be large depending on how deep the strike is set,” Iacono said. “Also, this will not help lender’s overall loan sizing, as they will continue to make their assumptions about take-out risk based on their views of interest rates, DSCR and cap rates.”
Fixing rates, increasing options
As well as in the US, the strategy is being seen in Europe, which has seen similar increases in base rates, as the European Central Bank and the Bank of England have battled inflation.
Prior to the current cycle of interest rate increases, the base interest rate in the eurozone was -50 basis points, with a lender floor of zero typically agreed, noted Duco Mook, head of treasury and debt financing for the EMEA region at Los Angeles-based manager CBRE Investment Management.
“At that time, if you had an average margin of 150 basis points, your all-in cost of debt was 1.5 percent,” Mook said. “We have now seen an increase in the base rate to roughly 3.3 percent and a margin which has increased by 150 to 200 basis points, which means a cost of debt of about 5.3 percent. This means you likely will be in breach of your ICR. But a cap has the effect of lowering the overall cost of your debt and allows you to comply with your ICR.”
One New York-based floating-rate lender noted his bank expects to see more borrowers use in-the-money caps but is not anticipating a flood of these transactions. “We won’t have 50, but we will definitely have a few,” he said. “If you prepay the interest and lock the rate, you can also sell that cap down the line, which means it could be an asset. In today’s environment, you must be creative to make your rate a fixed one or lower your pay rate – anything to bridge to a lower interest rate environment.”
The lender said much of his firm’s activity has been around providing one-year extensions for longer-term loans, a phenomenon that has been echoed by other lenders in the market.
Matthew Murray, executive director and head of EMEA servicing at London-based servicer Mount Street, said the firm started to see in-the-money caps come into play as short-term loan extensions have moved into short-term refinances.
“It makes a lot of sense from a borrower’s perspective because it keeps the total cost of funds down,” Murray said. “On a day-one basis, I see why borrowers are doing this, although for lenders it might be concerning because it is not entirely solving the problem. Lenders want to lend on an asset that has enough cashflow to service the debt and if they need to use a derivative to make it work, it could be a much bigger problem down the road if rates don’t decline.”
There are concerns, however, that the strategy will not prove effective for borrowers if the speed of interest rate declines is slower than expected.
“I think we have been in a little bit of suspended reality in our industry. A lot of what is going on is about buying time, not solving a long-term problem,” said Peter Merrigan, chief executive of Boston-based manager Taurus Investment Holdings. “You’re effectively pre-paying the interest to keep the loan in compliance with the lender’s interest coverage ratios.”
Most borrowers and lenders want to be able to survive the coming year and get to 2025, when there is a strong belief the Federal Reserve and other central banks will start to cut rates. “At that time, valuations will recover and, as a borrower, you don’t want to be forced to sell at what many think is the peak rate point,” Merrigan added.