Interest rate cap extensions and replacements in the current rate environment

As short-term rates remain high on the heels of the Federal Reserve’s historic tightening cycle, interest rate risk management is top of mind for many commercial real estate borrowers and other market participants. One common topic is interest rate cap extensions. Many floating-rate CRE loans — whether Agency, debt fund, bank balance sheet, lifeco, or CMBS — require the borrower to purchase an interest rate cap. These caps typically cover some portion or all of the initial term of the loan but must be replaced or extended if the borrower wants to remain in or extend the underlying loan.

In the current environment, SOFR is often higher (“in-the-money") than the strike rate on in-place caps and what is required for the cap extension or replacement. These replacement/extension caps are more expensive than originally budgeted and drag on deal economics. In this context, decisions related to cap replacements and extensions have become more consequential and strategic in nature. Apart from high-cap costs, some key themes have emerged:

• The inverted curve and forward hedge pricing: In a “normal” market with an upward sloping forward curve for SOFR, the cost to lock in pricing for future caps typically exceeds the current cost of an otherwise identically structured cap. In the current environment, with a downward sloping forward curve for SOFR, that is not necessarily the case. Depending on the structure, the cost of a one-year cap effective in one year is often less than the cost today of a one-year cap effective immediately. The graph below illustrates that in more detail, showing the costs of purchasing today: i) a one-year cap effective today, ii) a one-year cap effective in one year, and iii) a one-year cap effective in two years. It demonstrates how the downward sloping forward SOFR curve (reflected in forward swap rates lower than current swap rates) may allow a borrower to purchase an extension/replacement cap in advance at a “discount” to current prices (though they could still find in hindsight that pricing would have been even less expensive if rates fell more than priced into the curve).
• Intrinsic vs. option value: Many extension/replacement caps require strike rates that are in-the-money, below current SOFR. We’re seeing more cap structures where a greater percentage of the overall cost is "intrinsic" value, rather than “option” value. The former reflects the present value of the payment stream from the cap provider based on the forward curve (i.e., what the cap purchaser will receive if rates follow the curve) while the latter reflects what can be thought of as the “insurance value” of the cap (i.e., the value of the cap attributable to the possibility that rates may exceed the forward curve and provide payouts that are greater than expected). Understanding how each contributes to a particular cap structure is an important consideration for cap purchasers, particularly depending on their view of interest rates. Borrowers with a “higher-for-longer” view of rates may be more inclined to purchase a lower strike cap with a greater proportion of intrinsic value as they may view this as prepaying interest on a forward curve that is undershooting what rates will really do. The graph below includes bars distinguishing the intrinsic value and the time value of the cap.

• Pricing volatility: The partner “headline” to the rising rate environment has been the dramatic increase in interest rate volatility. Looking at both shorter-term and longer-term rates, realized volatility suggests that we’re in the most volatile rate environment of the past 20 years (with the possible exception of the GFC). Since cap pricing is driven in part by interest rates (specifically forward curves of the same tenor as the cap), there is corresponding volatility in cap pricing. In a recent analysis, we noted that the price for a $100M, two-year, 3.00% cap on SOFR over the past six months peaked at ~$4.25M and hit its trough at ~$2.5M, with the peak and trough coming within one month of each other. The graph below illustrates this, showing a time series of two-year caps on a $100M loan with several different strikes. It's very uncommon to see a market where the precise day of purchase has had such a meaningful impact on pricing.

• Agency caps and replacement cap reserves: Most floating-rate Fannie Mae or Freddie Mac borrowers know that their floating-rate products typically come with a requirement to purchase a cap and a requirement to reserve funds monthly to be used towards the purchase of a replacement cap. These monthly reserve requirements are reviewed periodically (usually every six months) with the following formula:

(Replacement cap cost – existing reserve balance) / months remaining on the existing cap)

Caps on Freddie Mac loans also adjust the formula above by multiplying the replacement cap cost by 125%.

As cap costs increase, these monthly reserve requirements will increase as well, and an early cap extension can help mitigate this. As an example, assume a situation where a borrower has 12 months remaining on an existing Agency cap and a meaningful balance in their escrow account. They could use that balance, which is otherwise unavailable to them, toward the purchase today of a one-year forward one-year cap, taking advantage of the pricing dynamics mentioned above with the inverted curve. The amount in the escrow account may heavily subsidize the purchase, and the next calculation to resize the monthly escrow payment will use 24 months in the denominator, rather than 12 months, significantly reducing that monthly expense. We’ve observed different Agency servicers taking different approaches on this.

With these themes in mind, we recommend that borrowers with interest rate caps that may require extensions consider the following:

• Track pricing closely: Given the current volatility in rates, significant week-to-week and even day-to-day movements in pricing creates windows where prices can decline dramatically for short periods of time and may present opportunities for clients that move quickly. We’re working with clients to provide pricing reports on large portfolios of cap extensions regularly and programmatically and can alert clients to significant favorable intraday moves.
• Understand pricing risk: Related to tracking, current pricing is understanding the range of pricing outcomes that might be observed if a cap extension is purchased in the future, at the expiry of the existing cap. A “buy now versus buy later” analysis on future cap extensions/renewals is something we’re doing frequently for our clients and other market participants to help them decide whether to extend an interest rate cap early.
• Be ready to trade: Borrowers that aren’t prepared to trade may miss out on these favorable opportunities. Being prepared includes having the right borrower SPE or other entity onboarded with a dealer bank that can trade on short notice and having the right decision criteria in place to know when you want to trade. These are both areas where we are actively working with borrowers.

Chatham can assist you with understanding these dynamics better and advise you on how they should factor into your hedging decisions, accounting for your specific asset and portfolio strategies and considerations. Please reach out to your Chatham contact or contact us using the form below.