What Are Rate Caps and How Do They Affect Your Property?
I’m going to start doing periodic education topics on how you, as a property management professional, can get a better understanding of the investment side of the business. I couldn’t think of a better way to start than with a topic that is greatly affecting multifamily investors across the country. Today, I want to briefly talk about rate caps.
Imagine you borrow money from a bank to buy an apartment building. When you get the loan, you agree to pay back the bank with interest. The interest rate is how much extra money you’ll pay on top of the borrowed amount.
Now, interest rates can go up or down depending on the economy. A "rate cap" is like a safety net for your loan. It puts a limit on how high the interest rate can go, even if rates in the market increase a lot.
So, if your loan has a rate cap, and the interest rates go up a lot, you won’t have to pay more than the cap amount. This makes it easier to plan your budget because you know there’s a maximum amount you'll have to pay in interest.
When you take out a loan with a rate cap, you're essentially buying insurance against high interest rates. Here’s how pricing for that cap works:
Premium Payment: Just like with insurance, you pay a fee to get the rate cap. This fee is called the "premium." It’s usually paid upfront when you take out the loan and added to the closing costs. The amount you pay for this premium depends on how high (or low) you want your cap to be and how long you want it to last.
Cap Level: The cap is set at a specific interest rate level, also known as a "strike rate." For example, if your loan has a floating rate, and the going interest rate in the market rises to 7%, but you set a cap at 5%, you’ll only pay interest up to 5% even if market rates continue to rise above that. The lower you set your cap level, the more expensive the premium will be because you are buying more protection.
Market Conditions: The cost of the rate cap is greatly influenced by current market conditions. If interest rates are expected to rise a lot, the cost of the cap will be higher because there’s a greater risk of having to pay higher rates. If rates are stable or low, the cap will be cheaper.
Duration: The length of time the cap covers also affects the cost. A cap that lasts for a few years will generally cost more than one that lasts for just one year.
To sum up, pricing for a rate cap is about paying a premium for protection against rising interest rates, with the cost influenced by how high the cap is set, how long it lasts, and the current interest rate environment.
So how does this affect investors today?
Well, a large portion of investors who purchased multifamily properties over the last few years used floating rate loans to finance those purchases. Many times they purchased a rate cap with a duration between 1 and 4 years, depending on what the lender required. At the time they bought the caps, rates were so low that the price was minimal. Let’s say $200,000 on a $30m loan. Fast forward a few years and now many of those rate caps are coming up for expiration and the investors are required by their loan documents to go out and purchase new caps. Unfortunately, due to an extreme rise in interest rates, those same cap levels are selling for $2m instead of $200k and owners have no choice but to use property cash flow or ask their investors for money to pay the premium. If owners don’t renew their rate caps, they could risk going into default with their lender.
This puts property managers in a unique position. There are many properties today that are performing operationally but are not performing as an investment due to cash flow being swallowed by high interest payments and rate cap renewals. You'll likely start feeling the pressure of this as we approach budget season as owners focus on ways to further increase revenue and cut expenses to balance the effects of higher interest rates.
So this begs the question, why don't owners just use fixed rates loans when they buy properties? That would take a whole post in itself to explain, but the short answer is that every cycle presents different opportunities and fixed rate loans are not without their own interest rate risks.
I hope this helps property managers better understand the investment side of the industry. I left out a lot of deeper concepts when it comes to this topic, but my main goal was to give an entry level overview of rate caps and how they affect multifamily.
Further education topics to explore: Defeasance, yield maintenance, SOFR, yield curve