Interest Rate Caps: The Top Hedging Strategies for Asset Protection
It’s imperative to put an economic ceiling on a loan as a means to protect yourself, as the borrower, against unpredictable interest rate activity. Interest rate caps can be purchased upfront as a proactive way to hedge the size of the loan. There are so many unknowns when it comes to the construction process, interest rate caps are a relatively low risk, preemptive investment to combat floating rates.
Before you break ground on a new project, make a point to get more information about securing an interest rate cap from your preferred lender. Many times, these caps take into account worse-case interest expenses associated with purchases and may be a condition to closing your construction loan.
What is an Interest Rate Cap?
Essentially, an interest rate cap is an insurance policy on a floating rate. There are three fundamental terms that make up the concept and overall cost of cap rate including the notional, term, and strike rate factors. Notional is simply the size of the cap, or the size of the loan it is hedging. The term is the length of time the cap is protecting the borrower from floating rates prone to increase. When the cap provider initiates payments back to the cap purchaser then the strike rate, an interest rate based on those payments, takes effect.
Basics of Interest Rate Protection
Because interest rate caps behave like insurance, they are often used as a means to protect unpredictable interest rates. By purchasing a cap, the borrower is directly protected by fluctuating rates but now has the additional security of a maximum interest rate. For seasoned investors and borrowers, making payments on the loan without being subject to interest rate inclines is a standard safety net in this current rental market.
Remember, the longer the coverage period, the higher the cost of the premium. Protecting against the risk exposure increases mainly due to market uncertainty and variable interest rates that follow purchasing a two-year cap agreement make the most sense here. Interest rate protection agreements are a commonly used hedging strategy, make sure to take the time to find a qualified and flexible lender who can secure a predetermined premium at the time of closing.
Types of Interest Rate Caps
There are three primary types of interest rate caps to consider. When you take out the initial loan, three different interest rate caps control how much your interest rate can fluctuate over time. As a raw data example, let’s say your mortgage payment has a 3% interest rate for the first 3 years, then experiences a rate rise to 5% for the next 10 years, then the remainder of the loan term you experience another hike to 8%, an interest rate cap puts a distinct and agreed upon ceiling limit on that rate.
This rate cycle is broken down into initial, subsequent and lifetime categories. Initial notes the first interest rate you experience in the beginning of the loan term, and subsequent notes the sequential rate rise or fall. The lifetime interest rate cap is the absolute maximum percentage your interest rate can rise over the lifetime of the loan. It is common to set the lifetime interest rate cap at 5%, which means your rate won’t exceed more than 5% higher than your initial rate (3%). It is advised to choose a lender that draws up an agreement that secures a low, initial, subsequent and lifetime interest rate cap across the board.
Use Rate Caps to Protect Interest Rate Hikes
Because the rate cap evaluation and execution process requires multiple steps and documentation, asset protection should be top of mind for experienced investors. To make it easy, contacting your lender approximately 2 weeks prior to project kickoff will prevent any delays. During the negotiation process, you and the lender will determine the cost and duration of the rate cap, all determined by the risk exposure. While the property owner for example may experience only a subtle increase in rental income, the market will more than likely see more of an overt rate hike at any time. Hedging the risk of a rate increase with an interest rate cap will protect foreseeable or unforeseeable rate inclines of this nature.
Broadmark Will Help Negotiate an Interest Rate Cap Agreement For You
Because Broadmark Realty Capital are specialists in smart, reliable and rapid financing solutions, We aim to help clients realize and fund opportunistic, truly unique real estate investments so finding the lowest cap rate is a priority for us so you can generate the most return. When you work with the Broadmark team, you develop a financial partnership for the lifetime of your investment ventures so unlike traditional institutions, there is no limit to our level of customer service.
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