059: Your Secret Weapon: Rate Cap Insurance
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So much goes on behind the scenes when it comes to investing, especially in the world of apartment syndication. There are always new acronyms to learn, tax hacks to remember, and insurance information you didn’t even know was a thing. 😉😉
I remember learning so much about this world of apartment investing and apartment syndication… and honestly feeling a little overwhelmed by the magnitude of not just the buildings we were investing in, but the vastness of all there was to learn.
One item in particular that topped the list for us on things we needed to learn was insurance– rate cap insurance more specifically.
Check out this episode, EP027 The No Cap on the Cap Rate 👈 about rate cap insurance and where the origins stem from. We won’t lie, this is some pretty “in the weeds” stuff.
Here’s the thing about weeds, sometimes you need to lower yourself in them, and roll around in their dirt, to really understand what you’re doing.
No one starts a garden without soil– and there are plenty of variations in just soil options! As any plant mom or dad will tell you, different dirt and nutrient combos produce different results for different types of plants. In a similar fashion, understanding different types of insurance to purchase with your assets makes you a better gardener.
We mean… passive investors! 😜😜
Regardless, your role as an investor is to see growth. Growth in your assets, growth in your income, and most importantly, growth in yourself! Knowing the details of your investments, like insurance types, only makes you a stronger, more in-demand team player.
So let’s dig—did you see what I did there?!—into today’s topic, we’re going to shine a spotlight on *ta-da the rate cap insurance that now a day goes hand in hand with bridge loans.
Love that. But before we dive deep into rate cap insurance, Would you say… In the past few years, Bridge Loans have become a very attractive loan type in apartment syndication? Why?
In the past few years, bridge loans have become a very attractive loan type for Multifamily Apartment Investors. 🤓🤓
#️⃣1️⃣ Bridge loans are shorter-term loans that typically match up well with the common multifamily syndication hold period of 3-5 years. (Compare to the Fannie Mae and Freddie Mac loans. And no, those are the names of I Love Lucy characters, they’re real loan companies!) With Fannie and Freddie, the term is a lot longer, between 8-12 years.
#️⃣2️⃣ Bridge Loans have grown in popularity for experienced general partners, these loans are easier to obtain for deals with higher upsides on the back-end.
#️⃣3️⃣ Rate Cap insurance has a low pre-payment penalty which expires after 18 months.
However, even these positive attributes can be outshined by the biggest concern for investors– the interest rate.
The interest rate can feel like a terrible roommate, you just never know what type of mood they’re going to be in that day. The interest rate is a variable that is adjusted monthly based on an index, and that index is usually the SOFR 30-day average.
The loan’s interest rate is adjusted monthly and is calculated by taking the agreed-upon index for example the SOFR 30-day average and adding a spread, no, not the great tasting one you put on an everything bagel, but the kind that the lender uses to earn their part of the cut.
For example, as of today’s recording, the SOF 30-day average is 1.01 assuming we get a favorable spread of 3.00, which means the interest on the loan will be 4.01%. And will circle back to this number again after we explain a little bit more about rate caps, we promise.
SOFR stands for Secured Overnight Financing Rate and has been published by the New York Fed since March 2020. The average calculations are based on interest rates over a given period of time. SOFR’s job is to smooth out the day-to-day volatility the markets can produce after a 30-day period. And a lot can happen in 30 days.
Can you see how the interest rate can feel like a moving target? 🤔🤔 While 2020 was a doozy of a year, so was 2009, the year of the Great Recession. The economy as we knew it was dwindling, fast. And the idea of an ARM loan– an adjustable-rate mortgage– was raising red flags.
The housing bubble during that time was caused by people who were buying single-family homes with ARM loans. Once the interest rate rose, these families buying homes– many of them, first-time home buyers– were forced into foreclosure because they were not able to support, or rather, adjust to the higher mortgage rate.
ARM loans and an arms race, are both dangerous, fleeting, and left a lot of people in shambles. All of this to say, this is where rate cap insurance comes into play. 🧐🧐
A Snap of the Rate Cap, And How it’s Used
A rate cap insurance is exactly that, an insurance policy. The purchaser (also known as the “borrower”) of the insurance pays a premium to a third-party company in case the floating rate index– AKA, SOFR– increases above a strike price or rate. 🙌🙌
Okay but back to rate cap insurance as it relates to the strike price. The interest rate caps can have an overall limit on the loan payment. 😇😇
So remember a little earlier when we talked about SOFR 30-day average index + spread = interest rate? So the rate cap insurance sets a maximum that the SOFR 30 day average index. If we have a rate cap at a 2% strike, this means that even if the SOFR 30-day average index goes to 3%, our SOFR will never exceed 2% + 3% which is the spread = 5%.
Cashflow Multipliers, did you catch that?
Did you catch that? Interest rate caps can give you, the borrower, protection against dramatic index rate increases and also provide a ceiling for maximum interest rate costs. So no matter the SOFR, and all its moving targets, variables, and changing interest rates, there is a cap on what you are expected to pay.
At the Top: The Rate Cap
Think of the cap as headwear protection– like a helmet ⛑️ – it’s strapped on to protect you from the floating interest rate hanging above your head.
Should the floating cap interest rate rise above the strike rate over the life of the cap, your helmet, aka cap insurance, serves to protect you so you’re not moving higher with the floating rate. Your helmet has kept you grounded, feet firmly on the floor and not up in the clouds with the influxes of floating rate changes. This might be the only time the phrase “the sky’s the limit,” is not the inspiration you thought it was. ✨✨
Should the floating rate move higher than the strike rate, your rate cap insurance serves to limit the financial damage. So where do you get this magical helmet used for protection? Where do you buy rate cap insurance? By making a single, upfront payment to the third part rate cap providers.
We’re fans of rate cap insurance because it’s one the of most efficient ways to combat an increase in floating interest rates and interest rate caps are commonly used to hedge short-term “bridge” financings. 🤩🤩
Caps offer many advantages over other types of interest rate hedges, such as ⏬
- A defined cost that is paid when the cap is purchased
- No prepayment penalty or termination cost
- Greatly reduced transaction cost
- Your cap can be totally customizable, to achieve the perfect balance of protection and cost
- Caps can be bid out between multiple providers to achieve to lowest available cost
- And lastly, rate caps can be transferred to other floating rate debt. Here’s a Kitti ninja (and you know hi-ya), if you are about to sell your property but you still own a rate cap insurance for the next 1 or 2 years, you can sell it at a profit and transfer the ownership to another property llc.
The Catch?
What is the point of insurance? To have protection, right⁉️ The same principle is applied to a cap. You’re buying insurance against potential future risk. The risk, in this case, is the interest rate your loan is based on increases so much that your project is financially damaged. 😉😉
Ouch, but this has happened from time to time. Our best advice to avoid this scenario is to buy the right policy at a fair price. Similar to buying car insurance, you’re shopping around to make sure you’re getting the most coverage for what you’re willing to pay. The full value of expert advice on your side develops after a cap transaction has closed.
Time is Relative… to the Cap
Hopefully, by this point, you’re excited about the potential of rate cap insurance and you’re ready to learn more about how to purchase one. Great! While there are several steps involved in getting the ball rolling on the rate cap know it all really boils down to one thing, derivative logic. 🙏🙏
Derivative logic is yes, technically a math formula in this case we’re referring to Independent Derivative, a hedge advisory firm.
A huge pro about Rate Cap Insurance providers is their ability to pull the trigger on rate cap insurance in as little as 24 hours. Our recommendation is to engage with the firm one week prior to the planned rate cap or loan close. Whatever you do, do not put yourself in a position where delays in the cap process also delay the loan close. Get in as early as possible!
But not to spook you, this again is the task of the sponsorship team who you’re investing with.
The Kitti Sisters Case Study
This is a real-life scenario that happened to us and illustrates how the rate cap insurance works. ➡️ We have $13,930,000 for notion and our cap duration is 2 years with a strike rate of 50 bps. The cost of the premium we purchased was $55,500.00, and as of last week we are already “in the money” and have started receiving the ACH, Automated Clearing House, for the interest rate cost above our rate cap ceiling– and this will continue for the duration of the cap. 😘😘
While our feet are firmly planted, and rates float above our head getting higher and higher, we know we’re making the best choice for our assets. Many people have commented that purchasing a rate cap insurance rate is as useful as buying a homeowner’s insurance policy. To that we say, it’s all fun and games until your roof gets smashed in by a falling tree.
Probably not so stupid then! For us, rate cap insurance is the cost of doing business. There is a time and place to look and save– like when you’re bargain hunting for new shoes– but when it comes to your investments? That is not the place to nickel and dime. 🙌🙌
Who do we have in mind with this process in practice? Our investors, of course! They’re the ones who are entrusting us with the apartments we choose and how they perform. Especially in this fluctuating economy. We want to say we have done everything possible to protect our investors’ interest, our assets, and rate cap insurance definitely plays into that!
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