What Is An Interest Rate Cap?
An interest rate cap, a.k.a “cap”, is essentially an insurance policy, purchased by a borrower, that protects them against undesirable movements in a floating interest rate, most commonly 1-month LIBOR or SOFR. Caps have three primary economic terms:
- Notional: the dollar amount covered by the cap, typically equating to the loan amount
- Term: the duration of the cap, typically two or three years, commonly shorter than the loan term.
- Strike Rate: the interest rate level, above which the cap will provide a financial benefit to the borrower.
The concept is best explained via an example: Let’s assume that the 1-month LIBOR Strike Rate in the cap is 2.00% and 1-month LIBOR rises to 2.25%. The cap provider – typically a bank – would pay the borrower 0.25%. While the borrower still pays the LIBOR-driven market interest rate of 2.25%, the cap allows them to “buy down” their effective interest rate to the 2.00% Strike Rate.
Why Do Borrowers Buy A Cap?
The cap creates a ceiling on the borrower’s floating interest rate. Should the floating interest rate rise above the Strike Rate during any month over the life of the cap, the cap’s insurance feature serves to limit the cap owner’s exposure to a move higher in the floating rate; if the floating rate moves higher than the Strike Rate, the Cap serves to limit the financial damage.
To buy a cap, the borrower makes a single, upfront payment to the cap provider, typically a bank.
Interest rate caps are one of the most efficient ways to hedge against an increase in a floating interest rate and are most commonly used to hedge short term, “bridge” financings. Caps offer many advantages over other types of interest rate hedges, like swaps, such as:
- A defined cost, paid when the cap is purchased
- No prepayment penalty or termination cost
- Cap owner retains exposure to the floating rate, should it move lower
- Greatly reduced transaction cost
- Totally customizable, to achieve the perfect balance of protection and cost
- Can be bid out between multiple bank providers to achieve to lowest available cost
- Can be transferred to other floating rate debt
What Determines The Cost Of A Cap?
To explain how the cost of a cap is determined, Let’s drill down on a few key variables mentioned earlier. The cost is driven by the mix of:
- Notional: Often referred to as the “size” of the rate cap, the Notional typically equals the loan amount that it’s being used to hedge. In general, the larger the Notional, the higher the cap’s cost.
- Term: The amount of time the cap is providing protection to the borrower. The longer the Term, the more expensive the cap. Each additional month of protection is typically more expensive than the previous month; said another way, a cap with a 3-year Term is much more expensive than a cap with a 2-year Term.
- Strike Rate: The level of the floating rate above which triggers payments from the cap provider (a bank) to the cap owner (a borrower). The lower the Strike, the more expensive the cap.
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For a defined mix of Notional, Term and Strike Rate, the cost of the rate cap will fluctuate over time based upon movements in the “underlying” floating interest rate, e.g. 1-month LIBOR or SOFR. The lower the underlying rate is relative to the Strike Rate the cheaper the cost of the cap and vice-versa.
In fact, how the financial markets expect the underlying interest rate to change in the future also has a big impact on the cap’s cost. If markets expect the underlying rate to increase over the Term of the cap, the greater the likelihood of a payout to the borrower increases, hence the more expensive the cap.
The hidden drivers of cap cost: Interest rate volatility. The more the underlying rate, e.g. 1-month LIBOR, moves around, the greater the likelihood that the underlying rate will spike higher than the Strike Rate. The greater the volatility in interest rates, the more expensive a cap becomes.
Finally, yet another factor that has a big impact on the cost of a cap: The Lender’s rating requirements. Most bridge lenders that require caps of their borrowers also require that the borrower buy the rate cap from a credit worthy financial institution. They manifest this requirement via verbiage in the loan agreement which defines “Initial Ratings” and “Downgrade Triggers”:
- An “Initial Rating” is a requirement by the Lender that the borrower purchase the cap from a bank that has a minimum credit rating – from the likes of S&P, Moody’s or Fitch – at the time the cap is purchased.
- A “Downgrade Trigger” is a requirement by the Lender that the Bank the borrower purchased the cap from maintain a defined minimum credit rating – again, from the likes of S&P, Moody’s or Fitch – over the Term of the rate cap. Should the Bank’s credit rating fall below the Downgrade Trigger, the Borrower must remedy the breach via the purchase of another cap from a Bank that meets the credit requirements.
In general, the higher the credit rating requirement, e.g. A+ S&P versus A- S&P, the more expensive the cap.
Can Any bank Sell A Cap?
No. While most of the large banks have the capability to sell the borrower a cap, most have limited interest, and thus are not competitive on price. There are only a handful of banks that specialize in caps and make a real business of it, having efficiencies in process and competitiveness in pricing. Further, even fewer of this handful of banks will participate in a bidding auction.
How much Lead Time Is Needed Before Starting The Cap Purchasing Process?
There are several steps involved in getting the ball rolling on the rate cap. While Derivative Logic can routinely orchestrate and help pull the trigger on the cap purchase in as little as 24 hours, we recommend engaging with us at least one week prior to the planned cap purchase or loan close. Pro tip: Don’t put yourself in a position where delays in the cap process also delay the loan close. Get us involved as early as possible.
What Documentation Is Needed To Buy A Cap?
Planning to purchase a cap requires documentation at several points in the process, specifically:
- Bid Package
- Dodd-Frank related, “Know Your Customer” disclosures
- Incumbency Certificate
- Collateral Assignment
- Derivative Logic’s Transaction Summary
- Legal Opinion
Lender’s that mandate borrowers buy caps are very familiar with what documentation is needed. Derivative Logic facilitates the generation, circulation and execution of all required documentation as you travel down the road toward your cap purchase and loan close.