What is an Interest Rate Cap?

The economic news has undoubtedly been dominated by inflation and interest rates during the latter half of 2021 and for most of this year. Investors in real estate and other sectors have closely monitored the Fed’s decisions over how much to raise interest rates to contain inflation.

We are going to look at how professional investors limit and manage such risk by purchasing interest rate caps because rising interest rates could increase the cost of borrowing and possibly influence the profitability of syndicated real estate investments.

What is a Cap on Interest Rates?

An interest rate cap, typically the Secure Overnight Financing Rate (SOFR), is an insurance policy for a floating loan.

What Purposes Serve Interest Rate Caps?

Borrowers use interest rate caps, a popular hedge used at all stages of the real estate cycle. They are utilized explicitly for debt with shorter terms on assets in transition that need flexibility for a refinance or sale. Interest rate caps allow an investment to be underwritten to an interest expense if necessary. Lenders offering a floating rate typically require a borrower to purchase an interest cap as a loan condition. Interest rate caps have a predetermined upfront payment and no early repayment penalty.

What are Interest Rate Caps’ Primary Elements?

Three vital economic concepts define an interest rate cap: the loan amount covered by the cap (often referred to as the “notional”), the cap’s term, and the level of interest rates (the “strike rate”) at which the cap will pay out.

What Factors Determine an Interest Rate Cap’s Price?

The cost of an interest rate cap to the borrower is determined by the three factors mentioned above;

Loan amount, or so-called “notional”: A cap with a higher amount is typically more expensive than one with a lower notional. 

Term: refers to how long the cap will protect the borrower; as you might assume, the longer the term, the more expensive the cap will be. Generally speaking, the cost of a cap of $50 million will be around twice that of a cap of $25 million. Typically, each month of the cap period will cost a little bit more than the month before;

The interest rate at which the interest cap provider starts paying the cap buyer or borrower is known as the “strike rate.” It is more likely that a cap provider will have to make a payment during the term when the strike rate is relatively low. Naturally, caps with fewer strikes cost more than those with more frequent strikes.

What Additional Factors Could Affect the Interest Cap Price?

The cap price may change in response to changes in one or more of the factors mentioned above, but cap pricing may alter over time in response to changes in:

Interest rate volatility: high levels of interest rate volatility suggest a greater possibility that rates would spike higher than the key rate, resulting in a larger payout for the cap seller; 

Changes in the key rate: represents expectations for SOFR over the cap’s period. The possibility of a payout to the cap purchaser increases when the key rate rises, which will induce an increase in cap cost. However, a decrease in the key rate is more likely to lead to a reduction in the cap cost;

Lender’s duration requirements: Lenders frequently demand that the period of a cap coincide with the original term of the underlying loan, though they may agree to a cap term that is shorter as long as an extension option is available;

Strike rate requirements of lender: a lender will frequently specify the strike rate for the cap; this is typically calculated using a minimum DSCR (debt-service coverage ratio) based on lender underwriting. Lenders will frequently require the term of a cap to coincide with the initial term of the underlying loan. However, they may agree to an initial cap term that is less than the initial term of the loan, provided a provision for extension (net operating income). 

Credit rating: many lenders need the cap provider to have a minimum credit rating from crucial agencies such as S&P, Moody’s, or Fitch. It is possible to have a structure with a strike rate that rises over time (a “step-up” strike); A fresh cap can be needed if your credit gets downgraded after you buy something. (also known as a “downgrade trigger”) Depending on their underwriting standards, different lenders may have differing degrees of flexibility on these parameters.

How Much Time Does It Take to Buy a Cap?

Before a planned purchase, the required due diligence may take up to two weeks to identify the most cost-effective and creditworthy cap providers.

What are the Forms of Identification Needed to Buy an Interest Rate Cap?

A vast range of data and paperwork must be submitted to purchase a cap, some of which include the following:

Data needed to conduct background checks on the borrower, its principal investors, and its executives, such as tax returns, business formation records, and details on the borrower’s ownership structure; Regulatory compliance: Documents confirming that the cap seller and the cap purchaser adhere to the necessary regulatory statutes must be filled out and signed by the cap purchaser;

Transaction summary: verifying the purchase and any significant economic terms, which the lender relies upon as proof of the purchase; Trade confirmation agreement: created by the cap seller following the completion of the sale, laying out the cap’s financial and legal terms;

Incumbency certificate: This document, which attests to the signatory’s capacity to carry out the trade confirmation and attests to the purchaser’s right to enter into the cap, must be submitted by the buyer of the cap; Collateral assignment; If a cap is purchased as a lender requirement for a loan, a collateral assignment is necessary. The cap seller produces these documents after the purchase is complete and outlines the cap’s economic and legal provisions.

As it relates to or could impact private equity real estate investment, Market Space Capital continuously monitors all pertinent economic data, such as interest rates. In syndicated real estate, minimizing risks as much as possible is crucial to success.

In some circumstances, especially when rates are expected to fluctuate, loans with floating interest rates may be advantageous. But to safeguard their passive investors from sharp fluctuations in the number of loan repayments and to maximize earnings, professional companies like Market Space Capital frequently buy an interest rate cap.

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MarketSpace Capital, LLC is a Houston, Texas-based private equity real estate development firm focused on ground up developments and value-add investments throughout the United States.

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Disclaimer: *For sold properties, actual sales price is reported. For active investments, the Estimated Current Value is based on the Managing Member’s estimate of current value. Recent acquisitions are generally valued at the acquisition price. Values may be internally prepared. This web-page/website is for informational purposes only and is qualified in its entirety by reference to the Confidential Private Placement Memorandum (as modified or supplemented from time to time, the “Memorandum”) of any offering of MarketSpace Capital.