Rate caps can be a confusing topic for many new multifamily investors. One of the reasons I believe it trips new investors up is because they do not fully understand floating rates.
Understanding Floating Rates
The best way to understand how floating rates work is to see it visually:
The most common index used in multifamily loans in the U.S. now is SOFR. SOFR or Secured Overnight Financing Rate is the interest rate at which banks lend to each other overnight.
SOFR is currently at 4.30% and closely follows the Federal Funds Rate set by the Fed. This is the floating portion of the of a floating interest rate. The spread is the fixed portion and usually lands around 400 basis points or 4%. Adding spread: 4% and index (SOFR): 4.30% gives you an all-in rate of 8.30%.
Asset type, condition and location can move the spread up or down. The spread remains constant throughout the loan and is determined in the loan application. The all-in rate will then move up or down depending on the index.
Read More: Top 3 Interest Rates to Follow in Multifamily
Defining Rate Cap
Rate cap is really what it sounds like. You are capping the rate. The cap strike rate is the interest rate you want to cap it at. For example if you buy a 2% strike then you are capping the index, in this case SOFR, at 2%.
To determine the all-in rate you add the spread plus the index, but since you bought a 2% strike you capped how high the all-in rate can go.
If the spread is 4% and SOFR is 4.30% the all-in rate would be 8.30% but since our strike is 2% the all-in rate is capped at 6%.
If SOFR goes below 2% then the all-in rate would be lower than 6%. In this scenario the cap would be considered out of the money.
The borrower is still paying the all-in interest rate on the loan but is being reimbursed by a cap provider from whom they purchased the strike.
In this case, the cap provider is paying 2.30% interest on the loan to the borrower since the strike is 2% and SOFR is at 4.30%. The borrower is effectively paying a 6% interest rate.
You can buy a lower strike rate or a higher strike rate. This depends on the deal and the borrower’s appetite for risk. It may also depend on lender requirements. Typical rate cap purchases are 2 to 3 years in length.
Calculating Rate Caps
The easiest way to calculate rate caps is by using available online tools. If you go this link: Pensford and download the Cap Pricer you can see how much a cap would cost using excel.
In this example I entered $20,000,000 on notional with a 36 month term at a 2.00% constant strike. This rate cap would cost $1,141,000.
Another easy online tool is Chatham Financial.
If you go to the Tools & Technology tab and then click on Interest Rate Cap Calculator it should take you to the online calculator.
From here you can enter your notional loan amount as well as what strike you wish to purchase as well as term.
In this example I did the same $20,000,000 loan amount with a 3-year term at a 2.00% strike. This cap would cost $1,119,000. It is important to note that these are estimates and change on a daily basis.
When purchasing a rate cap, it will be executed usually within 1 to 2 days before closing so it could vary from the day you get under contract to the day of close.
Conclusion
Knowing how to easily calculate the cost of a rate cap or approximate the cost will help when financially modeling a multifamily investment.
2022 was a volatile year that saw the cost of rate caps go up by more than 10X. This year could see more volatility in cap pricing so it is an important topic to understand and follow for multifamily investors.
