“Springing” interest rate cap requirements in CRE loans

A springing interest rate cap is a loan requirement to purchase an interest rate cap post closing if (and only if) the loan base rate (e.g., LIBOR or SOFR) crosses a predetermined threshold. They are typically negotiated in situations where the lender requires a hedge, but the borrower does not want to incur the cost of the cap at the loan close. This is often because the upfront cost of the cap would impair the deal economics and/or a belief that rates will not rise quickly enough to trigger the cap purchase requirement. An example of such a structure would be a requirement to purchase a 3.50% cap on SOFR through the initial maturity of a loan if SOFR reaches 2.50%.

The immediate benefit of such a structure is that the borrower avoids the upfront cost of the cap. Over the loan’s term, they may avoid the cost entirely if rates don’t cross the threshold triggering the purchase, or they may find that the cost of the cap is less than if they had purchased it upfront if rates do cross this threshold but no faster than originally expected at the time of the loan close. Conversely, if rates rise more quickly and/or more significantly, the cap requirement may be triggered and cost more than if the borrower had just purchased the cap at closing. This approach will often appeal to borrowers that hope to sell/refi the underlying asset well before the loan maturity or to borrowers that are simply willing to take the view that rates will be lower for longer than the forward curve prevailing at the time of the loan close.

With the recent rate hikes from the Fed and expectations for additional hikes this year and next, this structure has recently come up frequently in our client conversations, primarily in two contexts. First, many clients have reached out to help them evaluate their existing loan portfolios to understand if they have any loans with these provisions and, if so, what their requirements are. Through these conversations we have reviewed over 11,400 floating-rate loans, identifying over 650 loans with such requirements, spread across 100 distinct lenders. As the histogram below shows, many of these requirements have been triggered over the last several months as base rates like SOFR have increased.

The second context has been situations in which clients are looking at new floating-rate loan originations with hedge requirements. Given the substantial increase in the cost of interest rate caps since the beginning of the year, many borrowers and lenders have been exploring approaches for mitigating these costs. Springing caps have been one of several approaches we’ve seen employed in new loans to reduce upfront hedging cost.

In both of these contexts, a common conversation theme has been the timing for purchasing springing caps – should a borrower purchase a cap now to “get ahead” of a purchase requirement that may be triggered in the future (thus locking in a known cost today), wait to purchase the cap only if and when it’s required, or defer and re-evaluate the purchase at some future date. This is always a tough question to answer. At its root, this is a question of where rates will go and what cap prices in the future will be relative to cap prices today, neither of which are easily predicted. That being said, understanding some key concepts and considerations can give a borrower a better framework for considering springing caps:

Forward curve: A starting point for evaluating whether a borrower should “get ahead” of a springing cap requirement should be the current forward curve for SOFR/LIBOR. While the forward curve has historically been a poor predictor of rates, there’s some argument to be made that the front of the curve may be more predictive given how deliberate the Fed has been in telegraphing its policy decisions. As of October 7, 2022, the current forward curve shows 1-month Term SOFR hitting ~4.25% January of 2023 and peaking at ~4.40% in March 2023. A borrower with a “springing cap” triggered when SOFR hits 4.00% might be more inclined to purchase the required cap today, understanding that the market is projecting it may be required in a few months anyway. Conversely, a borrower with a cap triggered when SOFR hits 4.00% may be more inclined to wait and hope the trigger never materializes.

Borrower view of forward curve: Generally, so long as rates follow or undershoot the path implied by the forward curve any deferral of a cap purchase will make sense in hindsight. Similarly, a deferral may look like a bad idea in hindsight if actual rates exceed the path projected by the forward curve. With this in mind, a borrower that wants to take the view that rates are more likely to exceed the forward curve would be more likely to purchase a springing cap early and, conversely, a borrower more inclined to take the “under” on the forward curve should be more inclined to wait.

Interest rate volatility: It’s intuitive that the term and strike rate of a cap, along with the market’s implied expectations for future rates, can impact cap pricing. A less intuitive, but often just as significant, factor of pricing is interest rate volatility. This measure reflects the market-implied probability and the extent to which actual rates may deviate from the forward curve in a way that drives larger than anticipated payouts from the cap provider to the borrower. While it’s impossible to predict how volatility will change over time, the impact of volatility on a particular cap structure can be quantified. In this way, a borrower can gain an understanding of the magnitude of pricing risk that this factor introduces to a borrower considering deferring a cap purchase to meet a springing cap requirement in a loan.

Sensitivity of cap pricing: Cap pricing is sensitive to a variety of factors, including movements in interest rates, interest rate volatility, and the cap’s term. While we can’t predict how pricing will evolve over time, we can put numbers on how sensitive a cap’s pricing is to these different factors, and which factor plays a more pronounced role on a relative basis. For example, a 3-year, $50M cap with a 4.50% strike on 1-month Term SOFR would cost ~$945K today, with that value declining by ~$31.5K for every month of term that “burns off”, increasing by ~$5.6K for every 1 basis point move in 3-year rates, and increasing by $31.4K for every 1% movement in rate volatility. A borrower that is informed of these numbers will have better intuition on how the cap pricing might change over time and will be able to better evaluate the potential benefits of purchasing a cap now vs. waiting until later.

Asset strategy: As with all hedging decisions, the approach a borrower takes to a springing cap should be informed by the business plan for the underlying asset. A shorter hold period or window of refinance for the underlying asset should, all else equal, make a borrower more inclined to defer a springing cap purchase as long as possible, and vice versa if there is a longer anticipated hold period or window of refinance.

Lender flexibility: Irrespective of the loan language regarding a springing cap, a lender may be willing to waive or modify these requirements. We’ve seen several instances where our clients have been able to negotiate adjustments to these provisions with their lenders. It's worth clarifying, though, that lenders tend to view these situations on a case-by-case basis, factoring in heavily the underlying asset performance and their relationship with the sponsor. We’ve not seen any lenders agree to modifications on a programmatic basis.

Sensitivity analysis: As mentioned above, trying to predict future cap costs is a dubious exercise. That being said, we do think sensitivity analysis on what a cap cost might be in the future based on different rate environments can be a helpful exercise for a borrower to establish bookends around the range of likely outcomes and better quantifying the risk of deferring a cap purchase until later.

We hope this overview has been helpful. Please feel free to reach out to us if you’d like us to review your portfolio of loans to identify any springing hedge requirements. Also, feel free to reach out if you’d like us to help you think through how to handle a specific springing cap situation, whether that is to better understand when that requirement may be triggered or for a more thorough analysis around purchasing the cap now vs. waiting until later.