The benefits of interest rate caps at a time like this – Commercial Property Executive

Vishal Hotchandani

Over the past year, developers have faced rising construction costs due to inflation, global supply chain disruptions, construction demand and rising labor costs. -work.

CBRE Construction Cost Index predicts a 14.1% year-over-year increase by the end of 2022. Although the Fed’s policies of raising the federal funds rate and quantitative tightening to squeeze inflation out of the he US economy should eventually relieve automakers, in the short term, this will negatively affect their profitability by increasing financing costs. It’s no wonder that in recent months, borrowers considering starting construction projects have been asking their sources of debt capital for fixed-rate loans.

Almost all private lenders use leverage themselves – in the extreme case to generate higher returns for investors and in the modest case to manage fund cash flow. Providing a borrower with a fixed rate loan at a time when the lender’s cost of borrowing will increase would negatively impact the lender’s return to its investors. As responsible trustees, fund managers are unlikely to grant fixed rate loan applications. So, those who take on variable rate loans but are looking for stability when it comes to interest payments should look to the derivatives markets and consider buying an interest rate cap (IRC).

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In short, an IRC is an insurance policy. In exchange for a one-time premium, the CRI provider agrees to pay additional interest charges when the index on which the variable rate loan is based rises. The key terms to know when it comes to CRI are notional, duration and strike rate and the cost can be estimated by an online calculator.

For clarity, consider interest-only financing on the full loan amount of $30 million (notional) which is due after two years (term) and is offered at a rate of 1 month SOFR (1MTS) + 6 % (spread). Also assume that the IRC strike and 1MTS are both 3 percent at the time of closing. The cost of such an IRC would today be $821,000 (2.74% of the notional)3. The table below outlines the projected monthly interest payments to the lender based on the 1MTS forward curve4 and is broken down by amount paid by borrower and IRC provider.

In the example below, the borrower will have spent $821,000 for approximately $590,000 of coverage. It may not sound like a good deal, but different people value the peace of mind that insurance provides differently. Moreover, the forward curve of 1MTS is not static. Today it suggests that 1MTS will peak at 4.36% in March 2023, but only a month ago it showed the peak was 3.73% in May 2023. As the Fed continues to share its strategy with the market, the curve will surely change. Whether that changes enough, so that the coverage is greater than the cost, is anybody’s guess. Ultimately, the decision to purchase a LIRA should be driven by the borrower’s tolerance for interest rate risk.

Vishal Hotchandan is Senior Loan Originator, Parkview Financial.


1 “2022 U.S. Construction Cost Trends”; CBRE; https://www.cbre.com/insights/books/2022-us-construction-cost-trends

2 “What is an interest rate ceiling? » ; Derivative logic; https://derivativelogic.com/interest-rate-caps

3 “Interest Rate Cap Calculator”; Chatham Financial; https://www.chathamfinancial.com/technology/interest-rate-cap-calculator

4 “Forward Curve”; Pensford; https://www.pensford.com/resources/forward-curve

Remarks: (1) Most variable-rate, interest-only construction lenders only charge interest on the dollars drawn, which means the overall interest cost of the example loan would be much lower. Pricing an IRC for this type of product would also be less but impossible with any of the online calculators available; (2) IRC provider total is independent of spread and 6% has been used for illustrative purposes.

Stephen V. Lee