How to Reduce Hedging Costs on Floating-Rate Debt

It has been an eventful few months in the interest rate markets, with commercial real estate borrowers facing a much steeper forward curve and increased market volatility, both of which have contributed to significantly higher premiums on interest rate caps. For some structures, cap costs are as much as 20 times more expensive than they were a mere six months ago.

That sticker shock has led to a very common question: what are some creative solutions to ease the burden of that upfront cap cost?

Cap pricing is driven by market factors (think the forward curve and volatility) but also economic terms of the cap: the size of the cap (i.e., loan amount hedged), the term of the cap, and the strike rate (the level of protection). The most common approaches for reducing cap costs involve adjusting one or more of those terms:

• Term reduction: Cap pricing increases with longer tenors and decreases with shorter tenors. On lender-required caps, a potential alternative would be to buy a shorter cap at onset, with a requirement for a replacement cap to be put in place prior to the initial cap’s maturity. The borrower gets a reduced upfront cost in exchange for the risk that cap pricing is even higher when it’s time to replace the original cap. This may be a good trade-off for a borrower who expects to sell or refinance the underlying asset before the loan maturity, or if they want to take the view that rates won’t follow a course higher than currently implied by the forward curve.
• Increasing the strike rate: A cap with a higher strike will have a lower premium if the borrower and their lender are willing to live with the increased risk. One approach used frequently is a “step-up” strike structure, which entails a lower strike at the beginning of the cap and a higher strike (or strikes) at its end. These are often options in situations where the lender is underwriting net operating income growth over the loan – the higher NOI permits a higher strike while still supporting a similar debt service coverage ratio (DSCR). This structure makes particular sense in value-add and construction deals, where the bulk of risk is at the beginning of a project and interest rate protection needs to be tightest, but where this risk decreases over time as the property becomes cash flowing.
• Accreting cap schedules: In situations where a loan isn’t fully funded upfront, a borrower may consider structuring a cap to reflect the expected future debt balance instead of capping the full loan amount upfront. Depending on the size and timing of the draws, an accreting notional schedule could offer some concrete savings. This is commonly done for hedges on construction loans.

Apart from straightforward changes to economics, we’ve also seen some less common changes to the way these hedges are structured that can also improve pricing, including:

• Deferred premium caps: A deferred premium cap is a cap that is paid in installments over its life, rather than upfront with the loan close. A borrower can use this strategy to reduce the initial equity cost and potentially boost the internal rate of return. This structure may be available in situations where the lender has a swap desk and can offer a cap themselves, but likely won’t be available if the loan is with a debt fund or other non-bank lender. In addition to the typical profit that the cap provider charges, there will be funding costs levied by the provider that will need to be negotiated.
• Escrow structures: Various escrow structures can be used or contemplated either in conjunction with adjustments to lender requirements for a cap or in lieu of caps entirely. For instance, a lender can permit a one-year cap with a requirement to extend the cap an additional year (to the initial loan maturity) provided that the borrower escrow the estimated cost of the replacement cap at closing. This may make sense if the borrower anticipates a relatively quick sale/refi of the asset, or if they want to take the view that a one-year cap purchased in one year will be less than the second year of a two-year cap today (this is a big assumption, but it’s a view that some well-informed borrowers are willing to take). 
• Corridors: A corridor is a combination of a cap purchased at a lower strike (say 3.00%) and sold at a higher strike (say 5.00%). Like a cap, the borrower receives a payout if rates rise above 3.00%, but with the corridor that payment won’t continue to increase if rates rise above 5.00%. The premium received on the sold higher strike cap partially offsets the cost of the purchased cap at a lower strike. This offset in cost, though, exposes the borrower to any movement in rates beyond the higher strike and leaves them exposed in a worst-case rate scenario. With a corridor, a borrower is taking a view on rates, but that may make sense if they are convinced that rates aren’t likely to increase much beyond what the forward curve is already implying. While some borrowers are interested in this structure, many lenders are not comfortable with it as it doesn’t allow them to underwrite a worst-case interest expense and leaves borrowers unprotected beyond the higher strike.
• Collar: Interest rate collars involve combining a purchased cap with a sold floor. They allow a borrower to float while an index rate remains within a certain range but provide a known worst case above which rates can’t rise and a known best case below which rates can’t fall. The proceeds from the sold floor are intended to offset the cost of the cap and are, in fact, often structured so they perfectly offset, making the collar “costless”. Limitations include the fact that the sold floor requires a credit relationship – this structure won’t be viable on floaters provided by the Agencies or non-bank lenders. The sold floor also introduces prepayment risk if, at the time of an early loan payoff, the market has moved in such a way that the residual value of the floor is worth more than the residual value of the cap.
• Buy a cap/sell a cap: Several large funds in the market purchase a cap at the deal level to satisfy a lender’s requirement but then sell the identical cap at the fund parent level to recoup the cost. This may be combined with a fund-level swap if they still want to be hedged (but didn’t want to come out of pocket for the cap). Selling a cap to a dealer bank requires credit underwriting, and this approach is typically only available if the fund parent has some kind of unsecured line or facility that is expected to remain outstanding over the life of the cap. Additional regulatory analysis also needs to be done to confirm whether the fund parent would be in scope for posting variation margin (which may make this structure unattractive).

Chris Moore is a member of Chatham Financial’s Real Estate team, leading one of the group’s hedge advisory, execution, and technology teams and managing comprehensive client relationships. Karolina Brzozka is a member of Chatham’s Global Real Estate team, managing client relationships and comprehensive engagements for private real estate companies with emphasis on interest rate risk management.