Interest rate caps, swaps and floating-rate debt

Floating-rate debt prices at a benchmark rate plus a spread, adjusting periodically. When the benchmark moves, your payment moves.

Most bridge and construction lending is floating, and a significant volume of commercial term debt is too.

Why borrowers take floating debt

Lower initial rates, generally. More flexibility, since floating loans typically have lighter prepayment provisions. Availability, since certain lenders only offer it. And the expectation, sometimes explicit, that rates will fall.

The last of these is a forecast, and it deserves to be named as one.

Interest rate caps

A cap is a purchased derivative that pays the difference when the benchmark rate exceeds a specified strike, for a defined term and notional amount.

It limits your maximum rate. It costs money upfront and expires.

Most floating-rate commercial loans require the borrower to purchase one, with the strike and term specified by the lender.

The critical mechanics: a cap is priced on the strike level, the term, the notional amount and, importantly, market volatility and forward rate expectations.

When rates rose sharply, cap prices rose dramatically — in some cases by an order of magnitude. Borrowers whose caps expired mid-loan faced replacement costs that were budgeted at a fraction of the actual figure.

That was a significant and largely unanticipated cash drain across the industry.

The practical points: know your cap's expiry date, know the replacement requirement in the loan documents, and reserve for replacement at a cost well above what you originally paid.

Interest rate swaps

A swap exchanges a floating rate obligation for a fixed one. The borrower pays a fixed rate to the counterparty and receives the floating rate, which offsets the floating payment on the loan.

The effect is a synthetic fixed rate.

The difference from a cap is symmetry. A cap protects against rate increases and lets you benefit from decreases. A swap fixes your rate in both directions.

The consequence people miss: a swap has a mark-to-market value that can be negative.

If you swap to a fixed rate and rates then fall, the swap is out of the money. Terminating it early — because you sell the property or refinance — requires paying the breakage cost, which can be very large.

A borrower who fixed at a high rate and then wanted to sell into falling rates found the swap termination cost consumed a meaningful share of their proceeds.

Swaps are appropriate when the holding period is certain and matches the swap term. They are dangerous when the exit is flexible.

The floors nobody notices

Many floating-rate loans include an interest rate floor, setting a minimum below which the benchmark cannot go for pricing purposes.

In a low-rate environment this means the borrower does not receive the full benefit of falling rates.

Check whether your loan has one and where it sits.

Modelling floating debt properly

The failure mode is modelling at today's rate.

The correct approach is to model at several rate levels, including a level several points above today's, for the full loan term, and to check coverage and cash flow at each.

Then check what happens at the cap strike specifically, since that is your defined worst case while the cap is in force — and check what happens after the cap expires, since that is your actual worst case.

Include the cap purchase cost and the replacement cost in the cash flow model. They are real expenditures.

The 2022 to 2024 experience

Worth stating because it is the clearest available case study.

A substantial volume of commercial real estate, particularly multifamily bought during the low-rate period, was financed with floating-rate bridge debt and low-strike caps.

When benchmark rates rose several hundred basis points, the loans repriced. Caps that had cost very little to purchase provided protection until they expired, and replacement caps cost multiples of the original.

Debt service in many cases doubled. Properties that had positive coverage went negative. Distributions were suspended, capital calls were issued, and a number of deals were handed back to lenders.

Notably, many of these properties were operationally fine. Occupancy was solid and rents had grown. The capital structure failed, not the asset.

The practical positions

Prefer fixed-rate debt for long holds, and pay for it.

Where floating debt is necessary, buy a cap with a strike low enough to actually protect and a term matching the loan, not the minimum the lender requires.

Reserve for cap replacement at a multiple of the original cost.

Avoid swaps unless the holding period is genuinely fixed.

And model at rates well above current levels, because the entire lesson of the recent period is that the rate environment at origination tells you nothing about the rate environment at maturity.

General information about real estate finance, not investment advice. Derivative instruments carry specific risks including termination costs. Consult qualified financial and legal professionals before entering any hedging arrangement.