Far too often, commercial real estate owners looking to hedge interest-rate risk are asked to purchase derivatives and other financial products blindly. Rather than receiving transparency, borrowers are simply handed an invoice that they’re forced to accept. Unarmed to properly price hedging products and service providers, owners overpay for many over-the-counter commoditized products.
A primary example is interest-rate caps, a product often required on new floating-rate mortgages, including bridge and construction loans. Lenders intend for their borrowers to purchase caps with minimal additional cost, yet borrowers often pay brokers exorbitant fees for even this standardized product. Although brokers should simply charge flat, minimal fees, they frequently assess basis points on the loan amount even though each transaction is identical regardless of size. Some firms, however, including Rate Cap Advisors, have begun charging flat $5,000 fees rather than the antiquated model of charging basis points or percentages based on deal size.
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 against potential increases in interest rates by “locking in” a maximum loan interest rate, rate caps give borrowers the security of a cap on interest rates while still maintaining the opportunity to benefit from possible interest-rate declines in exchange for an up-front premium.
To better understand how rate caps work, let’s take a look at the exact structure of an interest-rate cap.
An interest-rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed-upon “strike” rate. An example of this would be an agreement to receive a payment for any period during which the LIBOR (London Interbank Offered Rate) exceeded 2.5%.
Rate caps can be purchased for any length of time but are usually taken out for periods of two to five years. The purchaser of a cap will continue to benefit from any fall in interest rates below the strike rate, which makes the cap a popular means of hedging a floating rate loan.
Rate caps successfully hedge risk to both parties—the lender and the borrower—against market fluctuations by adding a third party to the equation.
The third party, the cap provider, guarantees it will make any interest payments over the strike rate, protecting both sides from a catastrophic rise in rates. This allows banks to feel confident that the payments will never be missed even if interest rates skyrocket. It also provides the owner some peace of mind knowing that he or she won’t have to worry about paying exorbitant interest payments if rates go up.
Why Would You Want a Rate Cap?
Now, with all the costs associated with caps, why would you want to use one at all? For many owners, this question is moot, as most banks will require any floating-rate mortgage to have a rate cap attached to it. Thus, the real question becomes: How can you find the lowest cost possible?
Thankfully, the old system of rate-cap providers hiding behind the “mystery” of caps is ending, and borrowers are increasingly realizing that cap costs should and will be minimized for the future by using more forward-thinking brokerage firms.
How Does the Economy Affect Rate Caps Today?
The prospects of the economy in the long and short terms have an incredibly significant impact on all rate caps. The Federal Reserve has the power to manipulate interest rates, so it’s important to stay up-to-date with the news to be informed about which direction interest rates go.
The truth is, nobody knows exactly where rates will be in the future. But by staying abreast of interest-rate news in accordance with the rate-cap structure that’s in place, a borrower will be better informed and more likely to make smart decisions when determining the type of mortgage and rate to purchase.
In today’s economy, the Fed has moved toward an interest-rate hike that will lead to different borrowing behavior. This incremental increase in interest rates will make borrowing more expensive.
Ultimately, when interest rates rise based on various economic indicators and Federal Reserve guidance, it will be highly useful to have a rate cap in place on any variable-rate mortgages, to ensure that the final interest rate the borrower will be responsible to pay won’t exceed what’s indicated in the rate-cap structure.
Rate caps can be an excellent tool to help hedge borrowing to protect against any drastic increases for a variable-rate mortgage.