Interest Rate Caps Are Crushing CRE Deals Even More Than Before
As long as the Fed’s moves push the short end of the yield curve down, that will keep happening.
Three minutes before Ed Fernandez, president and CEO of 1031 Crowdfunding, speaks with GlobeSt.com, he’s writing off a project.
“I walked away from a deal I was supposed to go hard on before the end of today,” he says. Why/? Interest rate cap costs. To make things work would have needed a whole lot more capital.
“That means you’re using a tremendous amount of dry powder just to make one deal work,” he continued. “At these rates, debt causes negative leverage and that hurts your cash flow.” The irony was that they had the capital, but they also had investors. “You can’t deploy capital that won’t offer that return on the hope you’ll find another deal that will make a blended rate. It’s too much of a risk for us.” His investors would shake their heads, point to the ability to get 4.5% to 5% from a set of bank deposits with zero risk given FDIC backup, and walk.
Back in May 2022 it was clear that interest rate cap costs were crushing transactions. By October, the prices were even higher. And now/? The secured overnight financing rate (SOFR), frequently the basis for interest rate caps, has been a series of steps upward, ending at the current 4.8%. The short end of Treasury bond yields are similarly at highs since the early to mid-2000s, depending on the particular term.
Want a 3-year cap based on SOFR with a 3% cap strike rate for $50 million? According to Chatham Financial’s calculator, that’s $1,683,000.
The Wall Street Journal got comparative data from Chatham. The three-year cap at 3% for $100 million cost $98,000 in April 2019 and now is $3.48 million.
But interest rate caps often aren’t optional. “A lot of time, [property owners are] required to, they don’t have a choice,” David Scherer, co-CEO of Origin Investments, tells GlobeSt.com. “If you take out a Freddie Mac loan, you have to buy caps. They won’t let you do it otherwise. If you want to maintain the Freddie Mac loan, it costs millions of dollars, and a lot of people don’t have that. They have to find different ways of doing it.”
The cap costs are also twisting arms of owners to the breaking point because of short-term refinancing needs. Brookfield defaulted on $784M in loans for two high-profile Downtown Los Angeles office towers in February 2023. In an SEC filing at the time, the company said that it hadn’t exercised an option to extend the maturity date of the loans, which would have also required new caps.
Brookfield’s DTLA office fund warned in a November SEC filing that it was running out of cash and might start missing loan payments.