How Interest Rate Caps Work and Why LPs Should Ask About Them

Interest rate caps are an essential protection on floating rate debt. They put a ceiling on how high your borrowing cost can go.

Most LPs do not know how they work. Here is what you need to understand.

What a Cap Is

An interest rate cap is a derivative contract. The cap holder pays an upfront premium. In exchange, the cap pays out if the reference rate exceeds a defined strike price.

Example. A 5 percent strike SOFR cap on a 5 million dollar notional amount. If SOFR exceeds 5 percent, the cap pays the difference times the notional. SOFR at 6 percent on this cap pays 50 thousand dollars annually.

Why Lenders Require Caps

Floating rate lenders are concerned about borrower default if rates spike. A cap removes the extreme tail risk.

Lender requirements typically. Cap strike no more than 200 to 300 basis points above current market rates. Cap term covering at least the loan term. Cap counterparty rated investment grade.

The Cost of Caps

Caps are expensive. Cost depends on cap strike, term, and notional amount.

In a low rate environment, caps were cheap. Sometimes under 1 percent of loan amount.

In a high rate environment, caps are expensive. Three percent of loan amount or more is common.

On a 5 million dollar loan, a 3 percent cap costs 150 thousand dollars upfront. That is real money.

Cap Renewals

Cap terms are usually 2 to 3 years. The loan term can be longer. So caps need to be renewed periodically.

Renewal pricing depends on rates at the time. If rates moved against you, the renewal cap can cost more than the original.

LPs got hit by this in 2023 and 2024. Original caps expired. Renewal caps cost two to three times the original. Properties that did not budget for this had cash flow problems.

Reserve Funding for Caps

Good sponsors reserve for cap renewals from day one. Set aside cash each month so the renewal is funded when needed.

Sponsors who do not reserve for cap renewals are exposed. The renewal comes due and the cash is not there.

How Caps Show Up in Underwriting

The upfront cap cost should be in the closing costs. The reserve funding should be in the operating expenses.

If the underwriting does not reflect cap renewal costs, the projected cash flow is overstated.

Ask the sponsor specifically. What is the cap structure. What does it cost upfront. How are renewals being reserved for.

Caps Are Not Free

The cap protects you from rate spikes. It does not protect you from gradual rate increases.

If rates rise to the cap strike but not above, the cap pays nothing. You absorb the full increase. The cap is hurricane insurance, not climate change insurance.

This is why pure fixed rate debt is preferable when the property supports it. The cap is for properties that need bridge debt despite the rate risk.