Many developers are interested in ways to mitigate interest rate risk and caps are often at the top of the list. Structuring a cap around the draw schedule through a future anticipated sale/refi date is a common strategy, but the upfront cost often leads borrowers to seek out other options. Corridors are up next in our series related to hedging construction loans. If you missed our previous blast on collars, check it out here first.
Caps are flexible but can be expensive, swaps are restrictive but have no upfront cost, and collars fall somewhere in the middle. There’s one other structure that we haven’t covered yet – corridors.
If a borrower wanted to put protection in place, retain flexibility, and do so at a reduced cost, a corridor is a structure to consider. Corridors are just a combination of caps, one bought, and one sold, with the primary intent of obtaining cap like protection at a reduced cost. These are frequently executed when one or more of the following are true:
- There’s no lender requirement to hedge
- Borrower believes rate expectations are accurate or overdone
- The goal is to obtain some protection, but borrower is comfortable with the risk of a higher rate
- Borrower wants to hedge a longer term, but vanilla caps are too expensive
- Retaining prepay flexibility is important
When a cap is purchased, some portion of the cost paid is attributed to volatility/uncertainty. When a higher strike cap is also sold, a portion of the volatility is recouped, helping offset the cost of the initial purchase. Corridors are typically most beneficial in environments where a spike in volatility drives cap costs higher, or for longer term hedges.
As you learned in our resource The Hidden Driver of Cap Cost, costs generally increase exponentially with term, since each subsequent month has a greater level of uncertainty than the previous. For this reason, some developers prefer corridors since a hedge going out 3+ years can be structured at a reduced cost. The savings are often viewed as a cushion against rising rates that must be eroded before they’re worse off.
Read more about corridors in our 101 resource here.
What happens when I go to prepay. Do I face any sort of penalty?
Nope. Since the lower strike you purchased is always worth more than the higher strike you sold, the cap always has a NPV greater than or equal to $0.
- If rates are well below the strikes when the loan is paid off, the corridor can easily be terminated but is likely worthless.
- If rates are elevated, the corridor could be terminated, and the remaining residual value recouped.
Sounds like corridors check a lot of boxes. What’s the catch?
There are a couple of major considerations to keep in mind:
- Since corridors are a combination of two caps, they don’t put a hard ceiling on rates. Therefore, if rates exceed the higher/sold strike, your net rate begins increasing bp for bp. Said another way, the maximum payout you can receive from a corridor is equal to the difference between the higher and lower strikes, whereas a vanilla cap theoretically provides protection to infinity.
- Since they don’t put a hard ceiling on rates, corridors don’t satisfy lender hedge requirements.
My lender isn’t requiring a hedge and I just want some protection. How do corridors look cost wise currently?
Below, on the left, we’ve outlined pricing for a few structures for our hypothetical construction loan. For reference, on the right, we’ve included pricing for 4.00% and 4.50% strike caps from our cap resource.
If the buy 4.50% / sell 5.50% structure was executed, it would behave like this:
- If SOFR is below 4.50%, neither cap pays out.
- If SOFR is above 4.50% but below 5.50%, the bank owes borrower the difference between the bought strike and SOFR. It feels like a 4.50% vanilla cap, but the borrower paid ~58% less.
- If SOFR exceeds 5.50%, both caps come into play and are effectively a 1.00% drag on SOFR. In other words, if SOFR resets at 10%, the net rate will be 9%.
The last scenario above concerns me most about the strategy. What are my options if I execute a corridor and rates begin to rise unexpectedly?
Current market expectations put SOFR right at 4.50% in July 2025, meaning the buy 4.50% / sell 5.50% isn’t currently projected to payout. If the rate outlook shifts materially higher in the future, there are several options that can be used to further limit your risk.
Layer on a third “disaster” protection cap
This is referred to as a capped corridor. While it may turn out to be more expensive than a vanilla interest rate cap at the same max rate would have been, it does put a hard ceiling on your rate. For example, a third cap at 6.50% could be layered on, resulting in a max potential rate of 5.50%. More about capped corridors in our resource here.
“Buy to close” the higher sold strike
Under this option, you effectively purchase a cap at 5.50% to match the strike you sold. The net result is a ceiling on SOFR at 4.50%. All else equal, a 5.50% cap would be more expensive than a 6.50%, so this option would be more expensive than the previous, but obviously results in a lower capped rate.
Layer on a second corridor
The net rate begins to increase bp for bp when SOFR goes above 5.50%. If for example a buy 6.00% / sell 8.50% corridor was layered on, the risk is further limited. Under the 10% SOFR scenario, the net rate paid would be 6.50% (1.00% net payout from the first structure and 2.50% net payout under the second).
Layer on a swap
This is more restrictive due to the future potential breakage, but also avoids any additional out-of-pocket costs. If market rate expectations for the period of June 2025 – June 2027 jumped 1.50%, the swap rate would be around 5.80%. However, if SOFR is above 5.50%, the corridor would be paying out 1.00%.
5.80% swap – 1.00% corridor payout = 4.80% net rate
This is not an exhaustive list, and with the benefit of hindsight, it may be that none of the options look better than the vanilla 4.50% cap did at closing. However, there are numerous levers that can be pulled to further derisk down the road should you choose to execute a corridor today.
Tell me about structuring considerations.
Like caps, swaps, and collars, you can pretty much structure them however you’d like – there are just tradeoffs. A wider range between the bought and sold strike results in a higher cost (but more protection) than a tighter range of strikes. For example, the 4.50% / 5.50% cost is $240k whereas the 4.50% / 6.00% cost is $295k.
Shorter term corridors also have a smaller cost benefit than longer terms where there’s a larger volatility component. To help illustrate this, below we’ve broken down the cost of a vanilla cap at 4.50% and a 4.50% / 5.50% corridor for our hypothetical construction loan.
In the example above, the corridor costs $175k less than the cap. In order for the borrower to be worse off with the corridor, rates would need to be ~0.22%+ above 5.50% (or 5.72%+) between June 2025 and June 2027. To materialize, this would represent a 1.15% - 1.70% increase in current rate expectations.
If the 4.50% / 6.00% was executed instead, the upfront savings with the corridor would only be $120k. However, rates would need to be ~0.15%+ above 6.00% (or 6.15%+) for the full term to be worse off. In other words, an extra $55k bought an additional 0.43% of cushion.
The savings on longer-term corridors are greater but so are the potential range of outcomes. Below we’ve outlined what happens if we add on another year of term to our 4.50% / 5.50% example. The breakeven point increases to ~0.29% (or 5.79%+ SOFR)
Conclusion
Given the uncertainty around timing of draws and the ultimate sale/refi, corridors are a good alternative to caps since they’re cheaper but still retain flexibility. This is especially true when there’s no lender hedge requirement and borrower isn’t concerned about obtaining protection to infinity.
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