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Interest Rate Caps Multiplied 10 Times Since January

In: Finance

Adjustable-rate loans on commercial real estate — including about $350 billion of Commercial Mortgage-Backed Securities (CBMS) — almost always require interest-rate caps, a kind of insurance to protect monthly debt payments from soaring out of control when the Federal Reserve boosts rates.

Now that the Fed really is hiking, the cost of that protection has multiplied by 10 this year. For a $25 million mortgage, the cost was $535,000 in early May, compared with just $52,000 in January, for a two-year 2% rate cap, according to Chatham Financial Corp., a hedging advisory firm. Prices for the a similar three-year 2% cap rocketed up as much as 4,000%.

Chris Moore, a managing director at Chatham said: “Last year, it would be like buying flood insurance for your house in the mountains, this year, it’s sort of like buying flood insurance for your house on the beach as a hurricane is making landfall.”

The costs are high enough that it may prevent some investors in offices, hotels, malls or apartment buildings from paying for property improvements or potentially even closing a deal.

Rate caps are initially paid along with other closing costs, such as commissions and transfer taxes, soaking up about 2% of the principal at today’s prices.

A borrower with a two-year $25 million loan on an apartment building may have $500,000 less, for example, to buy new windows, flooring or other improvements.

The biggest sticker shock may come for borrowers who need to refinance or extend maturities on existing debt. Almost $125 billion of commercial mortgage-backed securities (CMBS) with adjustable-rate loans are maturing by the end of 2023.

More is in the pipeline: About 70% of CMBS and collateralized loan obligations originated this year and last are floating-rate debt, double the share before 2021, according to the Commercial Real Estate Finance Council.

The Fed has hiked rates by 0.75 percentage point since March as it tries to tamp down inflation, which already boosted expenses for property owners, such as lumber and labor.

The implied rate for Fed Funds Futures is almost 3% by February 2023, up from less than 1% today. The central bank has made it clear it will keep tightening, meaning more pain from rising rates is coming.

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