Interest Rate Cap – Hedge Against Rising Rates

An interest rate cap is a financial instrument that sets a maximum (cap) on the interest rate of a floating rate loan.  It’s a type of derivative contract that provides the purchaser protection against rising interest rates. 

If interest rates rise above the cap, the seller of the cap compensates the buyer for the difference – think of it as a form of insurance.  Caps are typically purchased upfront with a single payment, with the costs considering the loan amount covered by the cap (the notional), the duration of the cap (the term), and the rate above which the cap will pay out (the strike rate).  Interest rate caps are a commonly used interest rate hedge for borrowers, given it’s known upfront costs and no prepayment penalty.

Example:

XYZ Corp is purchasing a 58-unit apartment complex for $22,000,000.  The acquisition is being financed with a variable-rate, interest-only loan of $14,300,000 (65% LTV) on a 3-year term.  The interest rate is tied to SOFR with a 250-basis point spread.  An interest rate cap with a strike rate of 3.50% was purchased, limiting the all-in rate to 6.00% (3.50% + 2.50%).  The annual debt service for the first year without the cap would be $920,920, while the annual debt service with the cap would be $858,000.  This represents $62,920 of potential savings in the first year with the cap. 

In this scenario, the cap is “in the money” generating some savings that could be offsetting some of the upfront costs; however, note that if the strike rate was higher, let’s say 4.50% instead, the all-in rate would be 7.00% (4.50% + 2.50%).  This is above the rates without the cap in the example and is therefore “out of the money” and would not pay out.

Note that the 1-month Term SOFR is a forward-looking rate based on market expectations of SOFR over the next month.  There’s a decline in the forward-looking SOFR curve, which is likely due to the market expectations of The Fed cutting rates in this coming year.  Since SOFR is reflective of the cost of borrowing cash overnight collateralized by U.S. Treasuries, which is influenced by the Federal Funds Rate, it will generally move in the same direction as Fed policy changes.