Interest Rate Cap Costs Soar: CRE Borrowers Face Headwinds
By RadCRE Research · · Market Updates
Floating-rate CRE borrowers are grappling with significantly higher interest rate cap costs, with some pricing soaring by 200%+ compared to early 2022, impacting deal viability and refinancing strategies.
Interest Rate Cap Costs Surge, Pressuring CRE Lending
The commercial real estate (CRE) market continues to navigate a challenging landscape, with floating-rate borrowers experiencing a particularly acute pinch from soaring interest rate cap costs. As the Federal Reserve maintained its elevated benchmark rates amidst persistent inflation concerns, the cost of hedges designed to mitigate SOFR volatility has exploded, directly impacting deal economics and refinancing prospects for many property owners.
Data from market participants and financial publications like Commercial Observer indicate that a typical 3-year, 4.0% strike-rate interest rate cap, which might have cost a borrower 50-75 basis points (bps) of the loan amount in early 2022, can now exceed 200-300 bps, and in some cases, even higher for specific strike rates and tenor. This dramatic increase is largely attributable to the elevated and volatile SOFR forward curve, coupled with increased implied volatility in the interest rate derivatives market. With SOFR currently hovering around 5.3%, even caps struck significantly out-of-the-money are expensive. For instance, a $50 million floating-rate loan, a 300 bps cap cost equates to an upfront premium of $1.5 million, a substantial sum that erodes equity returns or necessitates additional capital injection.
Impact on Bridge Loans and Value-Add Strategies
The most immediate and profound impact of rising cap costs is felt by borrowers utilizing bridge loans, a prevalent financing tool for value-add acquisitions across many asset classes, particularly hospitality and multifamily. These loans, typically indexed to SOFR with spreads ranging from SOFR + 300-600 bps, almost always require the purchase of an interest rate cap as a lender covenant. The prohibitively high cost of these caps is making many previously viable projects uneconomical, especially those with tighter underwriting margins.
Consider a value-add hotel acquisition that relied on a bridge loan with a 75% loan-to-cost (LTC) ratio. If the cap premium alone consumes 3% of the loan amount, it effectively reduces the effective LTC ratio or increases the required equity contribution from the borrower. This dynamic is leading to a noticeable slowdown in new bridge loan originations and is forcing existing borrowers to either dig deeper into their pockets or explore alternative, often more expensive, mezzanine or preferred equity solutions to cover the cap premium and debt service shortfalls.
According to sources like the Mortgage Bankers Association (MBA), overall commercial and multifamily mortgage originations were down significantly in 2023, a trend expected to persist into late 2024. While higher interest rates are the primary culprit, the escalating cost of interest rate caps is an exacerbating factor, particularly for opportunistic strategies that rely on floating-rate debt.
Refinancing Hurdles and Distressed Situations
Existing floating-rate borrowers nearing their loan maturities face a double whammy: higher benchmark rates and expensive caps. Many who obtained bridge loans in 2021-2022 expected to refinance into permanent, fixed-rate debt in a lower interest rate environment. This expectation has not materialized, leaving them with the unenviable choice of renewing their existing floating-rate debt with an expensive new cap or seeking a new loan in a higher rate environment, both of which stress debt service coverage ratios (DSCRs) and increase the likelihood of loan defaults.
Lenders, particularly regional banks, are scrutinizing these situations closely, requiring borrowers to demonstrate sufficient liquidity to cover the higher cap premiums and debt service. This has contributed to an increase in distressed asset discussions, as some borrowers simply cannot afford the additional costs, leading to potential loan restructurings or foreclosures. For example, reports have surfaced regarding various multifamily properties in markets like Dallas and Phoenix struggling to refinance bridge debt due to these very issues, with some owners being forced to explore recapitalization options with new equity partners or potentially face special servicing.
RadCRE's Approach to Navigating Cap Costs
At RadCRE, we recognize the critical impact of interest rate cap costs on deal viability and client profitability. Our deep understanding of the capital markets allows us to proactively advise clients on strategies to mitigate these expenses. This includes exploring alternative hedging structures such as collars or participation agreements, negotiating for shorter cap tenors with potential for extension options, or even structuring preferred equity layers to fund cap premiums rather than burdening senior debt.
We work closely with a network of hedging providers to secure the most competitive pricing for our clients and provide clear financial modeling that integrates these costs into the overall investment analysis, ensuring transparent and realistic underwriting. Our advisory helps clients structure capital stacks that can withstand current market volatility while positioning them for future upside.
Tags: interest rate caps, CRE financing, SOFR, bridge loans, distressed CRE, commercial real estate capital markets, RadCRE
Sources: Commercial Observer, Mortgage Bankers Association, CoStar