Interest-Rate Caps Jump 900%+ for Adjustable-Rate Commercial Mortgages
Interest-Rate Caps, used to hedge floating rate commercial mortgages, have increased 900%+ in cost due to Fed hiking. For a $25 million mortgage, a 2-year rate cap cost $52,000 in January 2022. Today it would cost $535,000. 

Almost $125 billion in adjustable CMBS loans have schedules maturities by the end of 2023 - nearly 70% of CMBS/CLO securitizations this year have been adjustable rate products. The increase in rate cap costs are soaking up about 2% of the capital stack for acquisitions or refinances.

I am curious on how the increased cost of doing business will affect borrower's decisions. To me, it seems reasonable that a portion of those seeking floating rate CMBS will naturally transition into typical Bank/LifeCo fixed products to wait for benchmark rates to stabilize. What are your thoughts?

**Interest Rate Caps - [Chatham Financial Definition](https://www.chathamfinancial.com/insights/what-is-an-interest-rate-cap)**

An interest rate cap is essentially an insurance policy on a floating rate, most frequently SOFR. It has three primary economic terms: notional, term, and strike rate.

An interest rate cap has three primary economic terms: the loan amount covered by the cap (the notional), the duration of the cap (the term), and the level of rates (the strike rate) above which the cap will pay out. As an example, a $100M, 3-year, 3% strike cap will pay out if SOFR exceeds 3% over the next 3 years. This puts a ceiling on the purchaser’s all-in loan coupon of 3% plus their loan spread.
[{"id": "ibqt31s", "text": "Seems like the type of thing that can blow up horribly, small percentages of large amounts are a large amount, and when you have to pay one out because rates went up, if you have 30 other policies, you have to pay those out to, meaning pretty soon you are looking at systemic counter party risk,", "replies": [{"id": "ibr7y0j", "text": "They don't pay out a lump sum. They pay out the delta between the borrowers cost and the cap figure on an ongoing basis. Frankly, it sounds like they had gotten too cheap before (complacency from the issuer's chasing premium).", "replies": [{"id": "ibs2egc", "text": "Very solid point. During covid, I felt that banks were pushing swap products and IR caps for cheap as the issuers were chasing premium. I would say that 30 - 40% of the bank loans I originated last year had interest rate swaps, compared to 15% the years prior.", "replies": [{"id": "ibsa5xg", "text": "It was a great time to do swaps. Rates were stupid low and the yield curve was very flat so there wasn't too much difference in a 5, 7, or 10 year swap rate compared to historical.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ibqvel4", "text": "I work on conventional commercial mortgages of all sizes. We've seen a slow down in re-fi volume.  It's a much needed breather from the hectic last two (four) years. The balloons will keep business rolling in.   Acquisitions still need financing. Some appraisers are still out 4 to 6 weeks (but the SME appraisals are coming back to three weeks) and this backlog should soften.  Ultimately, there is a demand for square footage and finance is an expense that most ICRE/OCRE have to bear. Cap rates may soften around the edges but there's 400 BP of squish between cap/yield rates and a treasury. The NOIs depend on the macro-economy's response to the Fed's tightening, and wish I knew if we should expect a lock-up in 6 months from now from what occurred in Q2.", "replies": [], "depth": 1}, {"id": "ibtha4j", "text": "We\u2019re keeping our eyes on high leverage debt fund borrowers as a potential acquisition strategy. Something\u2019s gotta give with the syndicator groups of 2021 that no one\u2019s heard of buying low 3.0% cap institutional-grade multifamily trying to build to a 5.0% year 1  with a 70% tax reassessment assumption (sometimes none at all), $1200 payroll, physically impossible loss to lease burn off, and underwritten rents that are 20% above what their demographic can afford, but rationalized in a model that doesn\u2019t run the SOFR curve and shows a 19% IRR at a basis that\u2019s 125% of replacement cost.", "replies": [{"id": "ibthsdi", "text": "^already seeing a 30bp cap rate adjustment. Wait  for rates to continue to rise, 20% lease trade outs turn into 5%, controllable expenses increase 8% YOY, taxes get reassessed at 95% of PP, and you\u2019ve got a ton of deals that need to be taken off peoples hands", "replies": [], "depth": 2}], "depth": 1}, {"id": "ibz21rs", "text": "Thanks for posting that article explaining caps. Do you have any other resources you recommend that explain interest rate swaps in an accessible way?", "replies": [{"id": "ic7pb4f", "text": "Check out this [link](https://www.chathamfinancial.com/insights/what-is-an-interest-rate-swap) from Chatham. Great explanation on the structure of IR Swaps. \n\nTo break it down, there are two agreements in play.  A bank makes a fixed loan to its customer (Borrower). The bank then pays out the fixed interest rate payment that it receives from its customer, to a contracted counterparty (swap dealer), in exchange for a variable interest rate payment in return.", "replies": [], "depth": 2}], "depth": 1}]