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Understanding Rate Caps for Multifamily Real Estate Investors
If you're a multifamily real estate investor, you may have come across the term "rate caps." But what exactly are rate caps, and why are they important for your investments? Let's break it down in simple terms.
What are Rate Caps?
Rate caps are like protective shields for multifamily investments. They are contractual provisions that limit how much the interest rate on your mortgage can increase during a specific period. This protection is especially relevant when dealing with adjustable-rate mortgages (ARMs).
ARMs vs. Fixed-Rate Mortgages
Unlike fixed-rate mortgages, where the interest rate remains the same for the entire loan term, ARMs have rates that can change after an initial fixed-rate period. In commercial real estate, ARMs are classified as "floating rate" loans, but for this purpose we'll keep it simple and refer to the loans as ARMs. For example, you might have a 5/1 ARM, where the initial interest rate is fixed for five years, and then it adjusts annually or monthly based on an index and margin.
What is this index? This is where SOFR comes in to play...
How SOFR Rates Impact Rate Caps for Multifamily Real Estate Investors
In recent years, there has been a significant shift in the financial industry regarding the benchmark interest rate used for rate caps and adjustable-rate mortgages (ARMs). The Secured Overnight Financing Rate (SOFR) has emerged as the preferred replacement for the London Interbank Offered Rate (LIBOR), which was previously the most commonly used benchmark rate. As a multifamily real estate investor, understanding how SOFR rates impact rate caps is crucial for making informed financial decisions. Let's delve into the implications of SOFR rates on rate caps:
What is SOFR?
SOFR is a benchmark rate introduced by the Federal Reserve Bank of New York as a more reliable and transparent replacement for LIBOR. It is based on actual transactions in the Treasury repurchase market, reflecting the cost of borrowing overnight and secured by U.S. Treasury securities.
Transition from LIBOR to SOFR
Due to concerns about the reliability of LIBOR and its vulnerability to manipulation, global financial regulators decided to transition away from this benchmark rate. By the end of 2021, LIBOR was no longer considered a suitable benchmark, and many financial products, including rate caps and ARMs, began transitioning to SOFR as their new reference rate.
Impact on Rate Caps
SOFR's adoption as the new benchmark rate has several implications for rate caps and adjustable-rate mortgages:
Interest Rate Changes: Rate caps are designed to limit the increase in interest rates during each adjustment period for ARMs. With the transition to SOFR, the underlying reference rate for ARMs will now be based on SOFR instead of LIBOR. This means that the interest rate adjustments on ARMs will be influenced by SOFR, affecting how much your mortgage rate can change over time.
Potential Volatility: SOFR is generally considered to be more stable and reliable than LIBOR, as it is based on actual transactions. However, it can still experience fluctuations based on market conditions and economic factors. As a result, rate caps tied to SOFR may still need to account for potential interest rate volatility.
Adjustment Periods: The frequency of interest rate adjustments for ARMs remains an essential consideration. With the transition to SOFR, the adjustment periods may remain the same or change based on the terms of the loan. Investors need to be aware of how often the interest rates will reset to plan for potential changes in loan payments.
Understanding SOFR Trends: Monitoring SOFR trends becomes crucial for multifamily real estate investors. Keeping an eye on the SOFR index helps investors anticipate potential changes in their mortgage interest rates and evaluate the feasibility of their investments.
The Challenge of ARMs for Multifamily Investors in Today's Economy
When banks loan money to multifamily owner and operators, the terms of the loan are often tied to a fixed rate PLUS an adjustable rate tied to SOFR 30 day terms. Below is a chart showing the changes in SOFR rates since 2018:
Taking all of this into consideration, let's look at an example of a standard multifamily investment loan for $50M with an adjustable rate mortgage of 2.00% + SOFR, based on 30 day adjustable terms. Between May of 2020 to present, SOFR has ranged from 0.01% up to 5.08%. This means a monthly mortgage payment for $50M has jumped from a rate of 2.05% to 7.06% in 3 years:
When rates increase a monthly mortgage payment from $1.025M a month up to $3.5M a month, this directly impacts the cash flow remaining from the property. This cash flow is what investors typically receive their monthly or quarterly distributions from; if the cash flow has been largely spent on the mortgage, the impact for investors can result in diminished or even paused distributions until the rates begin to decrease and normalize. This has been one of the greatest impacts on multifamily investors from the Fed's push to increase interest rates.
The Solution: Rate Caps
Rate caps are there to keep you from facing wild fluctuations in your mortgage interest rates. They provide stability and predictability in your loan payments. So, during the adjustable phase of your ARM, rate caps ensure that the interest rate doesn't skyrocket, protecting you from sudden and drastic increases.
For example, if we use the same example as above, but put into place a rate cap of 2.75%, this means that whenever SOFR exceeds 2.75%, the cap begins to take effect. So, even if SOFR is 5.00%, the borrower will not ultimately pay more than the original term of 2.00% + 2.75% (the rate cap) = 4.75%.
However, there is one important factor to note: loans and rate caps come from different providers, similar to insuring your car vs getting a loan for your car. Multifamily owners will still have to initially pay the full amount to the lender due on current interest rates, and then is reimbursed for the delta between the total loan due and the max rate from the cap from the second provider after the fact.
If SOFR is lower than 2.75%, the cap is not relevant. So, while an owner might still have to face some increases in their monthly mortgage, for example a monthly mortgage payment from $1.025M a month up to $2.4M a month, there is a limit the cap puts into place to keep the expense from ultimately exceeding the maximum payout of $2.4M. While it's not enjoyable for anyone to pay out at the premium, it does protect the investment and investors as a whole from unsustainable expense in the long run.
Types of Rate Caps
There are two main types of rate caps:
Periodic Rate Cap: This cap limits how much the interest rate can increase during each adjustment period. For example, if the periodic rate cap is set at 1%, and the underlying index rises by 2% in a particular year, your interest rate will only go up by 1%.
Lifetime Rate Cap: This cap sets the maximum amount the interest rate can rise over the life of the loan. Even if the periodic rate cap allows for higher increases during each adjustment period, the lifetime rate cap ensures the rate won't exceed a certain level. For example, if the lifetime rate cap is 5%, your interest rate can never go beyond 5% from the initial rate, no matter how high the index or the periodic cap allows it to rise.
Key Takeaways for Multifamily Real Estate Investors
Rate Caps Reduce Volatility: Rate caps are contractual provisions that limit the increase in interest rates on your mortgage during a specific period. They offer reduced volatility and predictability in loan payments, protecting you from extreme fluctuations.
Commonly Associated with ARMs: Rate caps are often associated with adjustable-rate mortgages (ARMs). Unlike fixed-rate mortgages, ARMs have interest rates that can change after an initial fixed-rate period.
Two Types of Rate Caps: There are two main types of rate caps: periodic rate caps and lifetime rate caps. Periodic rate caps limit the interest rate increase during each adjustment period, while lifetime rate caps set the maximum amount by which the interest rate can rise over the life of the loan.
Origin and Importance: Rate caps for multifamily investments trace back to the creation of Fannie Mae in 1938. They were introduced to provide stability to the secondary mortgage market and attract investors to buy mortgage-backed securities.
Impact on Multifamily Operators: The cost of rate caps fluctuates based on several factors, including the current index, total loan amount, term of the cap, and forward yield curve. It's essential for multifamily operators to consider rate caps while planning their investment strategies and managing interest rate risks.
Reasons to Understand Rate Caps: Multifamily investors need to understand rate caps for various reasons:
Predictable Cash Flows: Rate caps help investors predict loan payments and budget effectively.
Mitigating Interest Rate Risk: They protect against significant interest rate increases, reducing the risk of unmanageable mortgage payments.
Evaluating Financing Options: Understanding rate caps helps investors choose between fixed-rate mortgages and ARMs based on their risk tolerance and investment goals. For the time being in today's economy, a fixed rate option, even at a slightly higher rate, may be more advantageous than ARMs due to the volatility.
Investment Analysis and Feasibility: Rate caps impact interest expenses, influencing the profitability of potential investment properties. The terms of a rate cap can be anywhere from one to three years, and if a replacement cap has to be purchased during a hold period, the expense can be as high as $1-2M.
Long-Term Financial Planning: Rate caps are essential for planning the long-term sustainability of investments.
Risk Management: Rate caps help manage risks associated with interest rate fluctuations, safeguarding investments from adverse market conditions.
In summary, rate caps play a crucial role in multifamily real estate investments by offering stability, protecting against interest rate risks, and enabling investors to make informed financial decisions. Understanding rate caps is essential for planning, managing risks, and ensuring the long-term success of a multifamily investment.
As always, Be Bold, Be Great, and Keep Pushing Forward!
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About Ellie Perlman
Ellie Perlman is the founder of Blue Lake Capital, a commercial real estate investment firm specializing in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology.
Blue Lake Capital is the sponsor of REady2Scale, a podcast that highlights the assets, processes, and strategies for the multiple approaches to successful real estate investing.
Ellie started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.
You can read more about Blue Lake Capital and Ellie Perlman at www.bluelake-capital.com.