Rate Caps Emerge as a Key Issue for CRE

Rate caps have emerged as a significant issue for borrowers, lenders, investors and servicers amid the rapid rise of interest rates. Nicholas Koluch, Senior Vice President, Asset Management, recently spoke about the topic on a panel at the annual conference of the CRE Finance Council (CREFC), the trade association for the commercial real estate finance industry, on June 14 in New York City.  

"Boots on the Ground: Challenges and Success Stories from the Servicing World," moderated by Richard Carlson, Managing Director, North American CMBS, DBRS Morningstar, examined the increased cost of rate caps, particularly as it relates to loan originations, extensions and modifications. 

Before the Federal Reserve began a series of 10 consecutive interest rate hikes ending in March 2023, rate caps were rarely implemented, as rates hovered close to zero and the caps were not "in the money." Today, cash outflows from rate caps are nearing $1 billion each month, one panelist estimated. 

As rate cap pricing has quickly accelerated, more portfolio and securitized borrowers are requesting non-standard terms. In fact, rate-cap negotiations are the most frequent consent requests servicers receive, the panelists agreed. These can range from requests to waive the cap requirement; reduce the time period for escrow to a one-year cap instead of two; offer a guarantee instead of a cap; or provide a letter of credit.  Some lenders and servicers may be willing to consider creative solutions where possible, for example, on non-securitized loans. Koluch provided examples of the type of evaluation involved in analyzing differing strike prices. 

Panelists agreed that despite the challenging environment, purchasing a rate cap is part of the cost of doing business, and borrowers need to be ready to provide the required capital. The key is to be thoughtful and responsive to borrower requests throughout the life of a loan or transaction. 

The panelists also discussed current challenges in cash management, particularly the cost and time involved in activating a cash sweep after a trigger event, as borrowers may disagree on whether the event occurred, and these situations can become litigious.  Koluch added that the increased focus on cash management is here to stay in the current market environment, and that lenders were very reluctant to agree to any modifications that reduce a lender’s coverage. A deposit account control agreement (DACA) is critical for cash management, because it offers servicers immediate control over a cash account, one panelist noted. 

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