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Why Are Rate Caps Wreaking Havoc For Commercial Real Estate Investors?

Low interest rates have not only become common place in the last decade they have become an expectation. So much so that many commercial real estate investors believed that there would be no material rate increases for the foreseeable future. That belief was fueled by various philosophies around politics, how the Federal Reserve would act and macro-economic trends. After the steroid infused real estate market, driven by aggressive Federal Reserve rate cuts to prevent an economic crisis as a result of the covid health crisis, investors gained even more conviction in this belief.

Why Did Rate Caps Become Popular For Commercial Real Estate Investors?

Investors will act based on their view of the short term and long-term outlooks. There is good debt and bad debt when investing in real estate. Given the expectation that interest rates would remain low for a long period of time it made sense to purchase real estate investments with variable (i.e adjustable rate) rate debt. Adjustable-rate debt is attractive in a low interest rate environment as it typically is less costly to exit and will have a lower interest rate than comparable fix rate debt options.

To offset the risk of interest rates rising, investors would purchase rate caps to help protect them if interest rates rose. No one expected them to rise however, at least not at the velocity which they have. As a result, many investors are facing, for the first time in their investing careers, a rising interest rate environment.

How does this impact both active and passive investors?

Before we get into that, you need to understand what a rate cap is (not to be confused with cap rates – another metric that investors may have made some incorrect assumptions about.)

What Is A Rate Cap?

A rate cap is a provision in a loan agreement that limits the amount of interest that can be charged on an adjustable-rate loan. In commercial real estate, rate caps are commonly used in loans that have interest rates that can fluctuate over time. Rate caps allow investors to have more certainty in analyzing an investment opportunity given they know what the max interest rate would be. Lenders may require that an investor purchase a rate cap as a condition to obtaining a variable rate loan. Rate caps protect borrowers from excessive increases in interest rates, but they can also cause problems for commercial real estate investors.

Rate caps are good for borrowers when interest rates are low or falling. These rate caps are more attractive to lenders however, if there is a rising interest rate environment. Rate caps can be set up as periodic rate caps to limit incremental increases in rates as well as put a “ceiling” or lifetime cap on the maximum amount that interest rates can increase to.

How Are Rate Caps Causing Problems For Commercial Real Estate Investors?

There is a cost associated with rate caps. The flexibility and low introductory rate available when using variable rate debt in conjunction with a rate cap is an advantage that makes variable rate debt more attractive to fixed rate debt in a low interest rate environment. As interest rates rise however, and there is more volatility in expectations around interest rates, – the rate cap price increases as well.

This is where the problem begins.

Lenders will require that borrowers escrow monthly costs for the replacement rate cap that the borrower will need after their current rate cap expires. This means that based on the expected cost of a replacement rate cap (typically recalculated every six months) investors will have to pay funds in preparation for the purchase of the new rate cap. The problem is that in a rising interest rate environment the price of the rate cap could have increased by more than 10 times what it was originally purchased for.

To put that in perspective, someone who purchased a $100,000 rate cap for a 2-year period may potentially need to start paying out $100,000 a month in escrow because the price of a new rate cap has increased to $1,200,000. As you can imagine, that would be a hit to the pocket. This would mean less cash flow to use at the property for renovations, executing the business plan, and paying out returns to investors.

Increased Cost Of Borrowing and Investing Risk

Rate caps can cause problems for commercial real estate investors by increasing the cost of borrowing. When lenders are restricted in the amount of interest they can charge, they may seek to compensate for this loss by charging higher fees and other costs associated with the loan. This can make borrowing more expensive for commercial real estate investors, which can reduce their returns and make it more difficult to earn a profit on their investments.

Furthermore, rate caps can increase the risk associated with commercial real estate investments. Deal sponsors may have, with good intentions, purchased rate caps and taken on riskier adjustable-rate debt. As a result, investments will not cash flow and provide returns as initially expected. As a passive investor if you are investing in a deal where the deal sponsor is using a rate cap, you should have a good understanding of what the contingency plans are around rising costs of rate caps.

Rate Caps During Uncertain Markets Can Freeze Transaction Activity

In addition to these problems, rate caps can also create uncertainty in the commercial real estate market. Investors may be hesitant to enter into adjustable-rate loans if they are unsure of how their interest rates will be affected by rate caps. This uncertainty can make it more difficult for investors to make informed decisions about their investments and can lead to a slowdown in the commercial real estate market.

How Should Syndicators Respond And What Will Be The Impact On Passive Investors?

These sudden changes in rate cap values are leading to liquidity issues for many investments. When there is a liquidity issue general partners will tend to try and resolve the issue internally first. There are several options to find new liquidity or change the in-place loan from variable to fix rate if financially feasible. If these options are not viable then there may be a capital call to passive investors.

Passive investors should look for syndicators who prioritize capital preservation. Further having a well-diversified investment portfolio will help protect you as a passive investor. You can diversify your investment portfolio by investing in various geographic areas, investing with different sponsors, different deal types, in funds and in single entity syndications amongst other things.

What Now?

In summary, rate caps limit the amount of interest that can be charged on an adjustable-rate loan in commercial real estate. These caps protect borrowers from excessive increases in interest rates but can cause problems for commercial real estate investors, including reduced loan availability, higher borrowing costs, increased risk, and market uncertainty. Investors should carefully consider the impact of rate caps on their investments and may need to adjust their strategies accordingly to address these challenges.

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