Interest rate caps… bag holder?
~70% of multi-family purchased in the last three years has been with debt fund higher octane leverage, who forced their buyers to get interest rate caps at closing. These caps are seriously in the money to the tune of 300-400bps on billions in loans. Anyone know who’s balance sheet these land on?
Someone is getting boned unless they then hedged all this interest rate risk which requires a lot more foresight than I would give our industry credit for in light of all the bad duration matching from the recent bank failures.
Would love to know more about how these are being paid during the next two/three years bc the generation fees up front cannot be worth it. Been digging around and hard to get an actual answer. Not including all these purchasers who are seeing their equity wiped out, especially on value add deals with groups paying a couple hundred grand a month to stay float out of their pocket.
Following.
Got a 0% cap revalued recently at 18x the premium we paid for it 2.5y ago. The price of these things not too long ago was a pittance, so I can imagine there are companies out there with large amounts of exposure getting royally screwed.
These caps are comprised of sofr futures and options on the sofr futures. They are being structured by banks that ostensibly have quality risk management in place and are expressing no directional movement. They provide flow and hedge themselves.
Huh? Where did you learn this stuff? Currently in development and kind of want to try out credit just to better understand that side of the business.
I almost took a career in trading back in the day and I stay up with that world. Rates move every market and are very important to follow imo.
You wont learn this in credit (lending). On lending side, thought process on caps rarely goes beyond % of notional hedged and at what strike (typically solved to create an all-in interest code which is x% headroom to sponsor case). While having an understanding of how rates work is very important, I wouldn't worry too much about understanding how rate derivatives are structured, leave that to the traders.
So you’re saying the buyer of these caps get all the upside, but no one taking the downside as it’s hedged/not taking directional exposure ? Genuinely curious
So let’s go back to derivatives 101. The most commonly used derivatives are options, futures, swaps, and forwards. People use derivatives for 3 things: hedging, arbitrage, and speculation. The purpose of caps in our industry is to hedge interest rate risk. When you call your bank (or Chatham/Pensford) to get cap quotes, they are looking usually at pricing on futures and sofr future options to structure the cap. With derivatives, there is no creation of wealth, only a transfer. When I am long a call option, someone is short that option. They are losing the same amount I have made or vise versa. When I am long a future, someone is short a future. One of us is making money and the other is losing money. There are a million permutations of derivative hedging, and when a market maker (trader at one of the investment banks or computer at the likes of citadel) sells a cap, it is generally immediately hedged out. I’ll give an example of how this is done with stocks. Say you want to buy a single call option on ABC. I sell you the call. You are long a call and I am short a call. I am short a call as the bank which means when when the stock goes up I lose money, so I buy 100 shares of ABC. Now I do not have directional risk (delta) and was still able to facilitate you with the call option on ABC that you wanted. Going back to SOFR caps, this same sort of thing happens. You as the developer have the cap that you wanted and I as the bank was able to facilitated that cap and then hedged myself.
These caps were for bridge loans and are expiring in the next 2-3 years. Borrowers better hope they can refinance out because nobody's going to buy these caps.
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