The Federal Reserve’s interest rate push is showing no signs of slowing down, which means that the prices for interest-rate caps (derivatives contracts that the lender sells and in which borrowers are paid when a benchmark interest rate is reached) are rising in tandem, and it’s putting real estate companies in a tight spot.
While interest-rate caps are not limited to the real estate industry, they can pack a big punch to the sector in a wobbling economy since most commercial transactions involve large amounts of debt. In effect, the caps protect businesses from sudden increases in rate benchmarks like the London interbank offered rate (LIBOR) or the Secured Overnight Financing Rate (SOFR). Companies are required to purchase these caps when obtaining additional debt and run the risk of defaulting if they break that covenant. The caps also restrict the amount of interest borrowers pay and reassure lenders that the risk of it hurting their clients’ capacity to pay back their debt is reduced. Real estate companies that rely on floating rate debt are frequently required by banks and other lenders to protect themselves with caps, but now interest rates are getting hiked with no end in sight, that hedge is getting expensive. Since the Federal Reserve increased interest rates from 3 percent to 3.25 percent last month, cap prices averaged $2.2 million in October (for a typical 4 percent, three-year, $100 million interest-rate cap connected to SOFR) up from $200,000 a year earlier and $45,000 two years earlier.
The real estate industry is already having trouble keeping up with rising labor and construction material costs as well as sluggish demand, but the explosive increase in interest rate caps is pushing some firms to find alternatives such as replacing them with fixed-rate debt or hedging their variable debt. Developers are even asking their lenders for leniency with requests for higher threshold rates. In any case, it’s clear that financing is coming at a steep cost with each interest rate hike, and it’s fundamentally changing how deals are done.