A.CRE

Interest Rate Cap

An interest rate cap is a type of derivative contract that provides the purchaser with protection against rising interest rates. It sets a maximum (or cap) level on the interest rate on a floating or variable rate loan. If interest rates rise above this cap, the seller of the cap (often a bank) compensates the buyer for the difference. In commercial real estate, caps are commonly purchased by borrowers to limit the risk of rising interest rates on variable-rate debt.

Modeling an interest rate cap involves modeling the floating rate debt, but with a MIN() function that ensures the all-in rate does not exceed the cap during the term of the cap.

Putting “Interest Rate Cap” in Context

Scenario Overview

Meadow Lane Capital, a real estate investment firm specializing in value-add projects, has acquired Garden View Apartments, a 150-unit garden-style apartment complex in northern New Jersey. The property was purchased for $25 million, with a planned $3.5 million renovation budget to upgrade unit interiors, modernize amenities, and enhance landscaping. The acquisition was financed with a $17.5 million variable-rate loan, representing a 70% Loan-to-Value (LTV), with the renovation funded through $3.5 million in equity contributions.

The loan is tied to SOFR (Secured Overnight Financing Rate) with a 2.5% margin, resulting in an initial rate of 5.0% (SOFR at 2.5% + 2.5%). The loan term is five years, with interest-only payments during the initial two-year renovation phase.

Interest Rate Risk Mitigation

Recognizing the potential for rising interest rates, Meadow Lane Capital purchased an interest rate cap to hedge against rate increases. The cap, with a strike rate of 3.5% SOFR, limits the all-in interest rate to 6.0%. The cost of the cap was $275,000, reflective of current market pricing for a five-year cap on a $17.5 million notional amount. Purchasing the cap was also a lender requirement to mitigate their risk exposure.

How the Interest Rate Cap Works

The interest rate cap ensures that if SOFR exceeds 3.5%, the cap provider (a major bank) compensates Meadow Lane Capital for the difference between the actual SOFR rate and the 3.5% strike rate. Here’s an example of how it operates:

  • If SOFR rises to 4.0%: The loan’s all-in rate without the cap would be 6.5%. With the cap, SOFR is effectively capped at 3.5%, limiting the all-in rate to 6.0%. The cap provider pays Meadow Lane Capital the difference (0.5%) on the $17.5 million notional amount.
  • If SOFR remains below 3.5%: Meadow Lane Capital pays the actual interest rate, with no compensation from the cap provider.

The cap offers predictable debt service costs during the renovation phase and initial stabilization, where cash flow may be limited due to reduced occupancy and increased capital expenditures.

Financial Impact

The interest rate cap provides peace of mind and financial stability during a period of heightened interest rate uncertainty. For example, if SOFR rises above the strike rate, the cap significantly reduces debt service costs:

  • Loan Balance: $17.5 million
  • Without Cap (SOFR at 4.0%): All-in interest rate = 6.5%, annual debt service = $1,137,500
  • With Cap (SOFR capped at 3.5%): All-in interest rate = 6.0%, annual debt service = $1,050,000
  • Annual Savings: $87,500

Over a two-year period of elevated rates, the cap could generate significant savings, offsetting a portion of the upfront cost.

Trade-offs and Risks

If SOFR remains below 3.5% for the duration of the loan, the interest rate cap will not trigger, and Meadow Lane Capital will not recoup the $275,000 upfront cost. However, this is a calculated trade-off: the cost of the cap is a form of insurance, protecting the project from unforeseen spikes in interest rates that could jeopardize financial stability or compliance with lender covenants.

Additional Considerations

  • Debt Service Coverage Ratio (DSCR): By limiting interest costs, the cap helps Meadow Lane Capital maintain a DSCR above the lender’s minimum threshold, ensuring compliance during the renovation phase.
  • Lender Requirements: Many lenders mandate interest rate caps for variable-rate loans to protect both the borrower and the lender from unexpected rate increases.
  • Market Trends: The 3.5% strike rate reflects expectations of rising SOFR rates during the loan term, balancing affordability and protection.

Conclusion

The interest rate cap is a vital component of Meadow Lane Capital’s financial strategy for Garden View Apartments. It aligns with the firm’s value-add investment plan, ensuring predictable debt service costs while providing protection against rate volatility during a critical phase of the project.

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