Eitan Weinstock

Commercial real estate owners looking to hedge interest rate risk are often asked to purchase derivatives and other financial products blindly. Rather than receiving transparency, borrowers are simply handed an invoice that they are forced to pay. Unarmed to properly price hedging products and their service providers, owners overpay for many over-the-counter products.

A primary example is interest rate caps, a product often required on new floating rate mortgages, including bridge and construction loans. Although lenders intend for their borrowers to purchase caps with minimal additional costs, borrowers often pay brokers exorbitant fees for even this standardized product. Although brokers should simply charge flat, minimal fees, more antiquated firms frequently charge percentage points on the loan amount even though each transaction is nearly identical.

Firms such as Rate Cap Advisors (RCA) have shifted the market by charging flat $5,000 fees rather than the antiquated model of charging basis points or percentages based on deal size. In the past, purchasing a $50 million rate cap would cost $18,500 in third-party fees alone. Like Silicon Valley startups, RCA helps commoditize the real estate hedging field, lowering costs for borrowers and lifting the veil off a previously opaque industry.

What Is A Rate Cap?

Rate caps are the most common method for protecting against rising interest rates. Essentially serving as an insurance policy for both the property owner and lender (i.e. it doesn’t help anyone if rates rise to 14 percent and the borrowers default on their loans), rate caps lock in a maximum loan interest rate. Borrowers get to have their cake and eat it too by gaining the security of a maximum interest rate while obtaining the opportunity to benefit from drops in interest rate.

Most rate caps follow identical structures: the lender dictates deal loan amount, strikes rate and term, and the cap simply needs to match these requirements. In the example below, a borrower on a $50 million loan is capping one-month LIBOR at 3 percent over the next three years. Any time LIBOR exceeds 3 percent, the borrower will be reimbursed the difference by the bank providing the cap.

Rate caps can be purchased for any length of time but are usually taken out for two to five years, with the average being three.

Strike rates can be purchased at any level but are usually 2.5 to 4.5 percent, with the average being in the 3 percent range.

Rate caps effectively hedge risk for both lender and the borrower against market fluctuations by adding a third-party to the equation. The third-party (the cap provider) guarantees that it will make any interest payments over the strike rate, protecting both sides from a catastrophic rate rise. Banks can feel confident that payments will never be missed even if interest rates skyrocket. It also allows the borrower will not have to worry about paying exorbitant interest payments if rates rise.

Why Would You Want A Rate Cap?

In most cases, new lenders require borrowers to purchase rate caps in conjunction with new floating rate mortgages. The only question is how to find the lowest rate possible. The old system of rate cap providers hiding behind the “mystery” of caps is ending and borrowers are increasingly realizing that cap costs should be minimized for the future by using more forward-thinking firms.

How Does The Economy Affect Rate Caps?

As interest rates rise, cap costs generally rise as well. The more likely a borrower’s strike rate to be hit, the more expensive the cap becomes. With widespread expectations of continuing Federal Reserve rate hikes and rising interest rates in general, now more than ever borrowers are looking to purchase rate caps in order to purchase at lower costs and simultaneously protect themselves from expected market movements.

Ultimately, understanding rate caps and their costs is one of the most valuable tools for real estate owners. Rate caps are the prudent and efficient way to hedge against increases in interest rates and borrowers are increasingly educating themselves about the importance of working with the most transparent providers available.

Eitan Weinstock is managing director of Rate Cap Advisors (RCA).

The Future Of Rate Caps Shifts To Flat Fees

by Banker & Tradesman time to read: 3 min
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