When it comes to predicting cashflows, the forward curve is the standard assumption, but if there’s one thing we know for certain, it’s always wrong. Long time readers are familiar with the “hairy curve” included in our fix vs floating study here.
The takeaway is, in general, the market dramatically overestimates the path of rates. The most notable exception to this, however, is during a tightening cycle when the FOMC is hiking interest rates.
The graph below zooms in on the last five cutting cycles by comparing market rate projections around the time of the first cut to actual Fed Funds.
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- Dotted lines – the amount of easing priced in just before the first cut
- Solid lines – the actual amount of easing
- Grey line – the solid portion represents cuts to date, and the dashed portion represents the current forward curve
Takeaways:
- Over the past five cycles, markets were pricing in roughly one to three 0.25% cuts around the time the first occurred.
- Except for 1995, the market has underestimated the magnitude of rate cuts.
This cycle has been anything but typical, but one might believe there’s a chance the market is overestimating the path of rates again.
The following graph outlines the amount of easing priced in by markets between the observation date (Y axis) and years ending 2025 and 2026. This was calculated by subtracting spot SOFR on the observation date from the SOFR futures contract for the respective year end.
The market has aggressively priced in rate cuts (roughly 2.25-2.50% worth) three different times over the past two years. Since rate expectations drive hedge costs, these points (Mar-May 2023, Jan 2024, and Aug/Sept 2024) represent dips in hedge pricing. If you had to hedge, with the benefit of hindsight, each time provided a good opportunity to do so.
- Since August, the Fed has cut 1.00%, but the market has also backed out another 1.00%+ of easing. Therefore, at the time of writing, roughly only 1.5 more quarter point reductions are priced in.
As rate expectations have increased, cap costs have increased 25%-100%+ from the September low. If you’ve looked at hedging recently, then you’re probably aware that none of the options today feel like “no brainers.”
So, how does one approach hedging, given where we may be in the cycle, and the uncertainty about what lies ahead?
There are a few options we’re frequently seeing.
Follow the lender’s minimum requirement
You know this one already. It typically consists of purchasing a series of shorter-term (eg 1-2 year) rolling interest rate caps at the max strike. The caps are extended for another year prior to maturity, but not much else goes into it.
Benefit
If rate expectations are overdone, this works pretty well. By purchasing the shortest term and highest strike, the potential value that would be eroded by rates falling is minimized.
Downside
If rate expectations aren’t overdone or are even higher in the future, then a series of caps could be exponentially more expensive than a longer-term cap is today. Everyone is familiar with this risk by now.
Quantifying the future cost in a similar or higher rate environment is possible too. We run these sorts of scenarios for clients all the time.
Middle ground
A proactive approach is to monitor the cost of the future cap extension on a monthly or quarterly basis. This is an easy way to keep tabs on the market and helps avoid being caught off guard in 11 months. If the market outlook begins to shift, we can always jump on a call to discuss if extending early makes sense.
Want help monitoring the cost to extend the various hedges in your portfolio? Just let us know. We’ve got you covered, even if we didn’t place the initial trade.
Aligned with the business plan
This might be a medium-term hedge (3-5 years) where the maturity is aligned with a target disposition date. Alternatively, the investment might be a longer-term hold with a 7-10-year fixed rate, which while less exciting at 6.50%-7.00%, still pencils. If your focus is offloading rate risk to someone else, there’s something to be said about peace of mind.
Benefit
If rate expectations are overdone, this still works well. You mitigated your rate risk, which was the goal to begin with!
Downside
Cap costs, while meaningful, are still manageable out to 3-5 years. Beyond that, they become prohibitively expensive, so a 5+ year hedge often ends up being a swap (when able). If rate expectations are overdone, you locked in a swap, but need to prepay early, the potential breakage could be significant.
Middle ground
A lower strike cap could be purchased for the earlier years of a loan and a higher strike cap or corridor for the later years. This limits the exposure over a longer period at a lower upfront cost.
Hybrid strategy
Now we’re talking. This is likely a combination of the above but using different hedge types, laddered maturities, step up/down strikes, etc.
Hybrid strategies seek to balance risk and cost today, while keeping an eye on the future. The goal is NOT speculating to make money on derivatives or to overcomplicate hedging strategies to justify a fee.
Below, we’ll look at a couple recent examples we’ve seen using generic numbers and current pricing.
Example 1
Overview - $100mm loan, bank lender, 3+1+1, minimum 1 year hedge at a 5.00% strike, but borrower desired protection for the full initial term.
Here are a few options to cover all 3 years with minimal cost.
The borrower in the scenario was interested in swapping but indicated a sale after EOY 2 was possible and was concerned about the potential breakage. Below is a table outlining what that might look like over time and under different rate environments.
By way of example, if 1 year remains and rates are 1.00% below current market expectations (implying a 3.02% 1 year replacement rate), the swap breakage would be $1.21mm.
One option that eliminates the potential breakage is to execute a 2 year swap and purchase a max strike cap for year 3. Here’s where that shakes out.
The borrower preferred not to come out of pocket for the cap, though. Therefore, we looked at a forward starting costless collar to cover year 3. The floor on that structure would shake out around 3.50% today.
This ended up being the ultimate path.
Like swaps, costless collars also have the potential for a breakage if they’re unwound early and rates are lower. However, the penalty is often much less than that of the equivalent swap. The table below outlines the year 3 collar breakage under the same rate shocks.
And here is the percent decrease in the breakage by having a collar year 3 (in lieu of a swap).
Some notes:
- The borrower satisfied the hedge requirement all 3 years, reduced the potential breakage in year 3, and didn’t have to come out of pocket to do so.
- If the borrower doesn’t end up selling in year 3, they still have the max protection in place but retain the ability to float down to 3.50% (or 0.50% below current expectations).
Example 2
Overview - $100mm loan, bank lender, 3 year term, 3 year hedge requirement at 4.85% (or a 1.25x DSCR).
This example starts off a lot like the previous – the borrower needs a 3 year hedge with a max rate of 4.85%. Here’s pricing on the same three full term hedging options.
The borrower in this scenario wasn’t excited about swapping 100% for the full term but didn’t want to pay for a 100% cap, either. The goal was to refi in 12 months, so limiting the potential breakage along with minimizing costs was important.
Some common alternatives were considered, which included asking for a shorter-term hedge, requesting a higher strike, and a springing cap requirement. However, where we ultimately settled was a hybrid strategy with a 50% swap and 50% cap.
Since the swap rate was below the 4.85% requirement, the cap strike could be increased to 5.56% and still provide a max blended rate of 4.85%. Here are the new hedge costs, and what the borrower ultimate chose.
Some notes:
- The borrower satisfied the hedge requirement all 3 years while reducing the upfront cost and mitigating the potential breakage.
- In lieu of paying for a 50% cap, the borrower could have elected a costless collar which would have a floor around 3.25%. However, retaining more exposure to floating rates and limiting the potential prepay penalty was of greater importance.
- While a cap could have been purchased for years 2 and 3 to eliminate the potential breakage, the cost was not much less than a full-term cap.
- Borrower could have executed a 2 year swap and purchased a cap for year 3, but that didn’t help much on the potential swap breakage.
- A 2 year 100% swap with 1 year remaining has a breakage which is similar to a 3 year 50% swap with 2 years remaining (under similar rate environments). Since the goal was to refi in 12 months but the swap breakage would be similar, the option with the lower cap cost was of greater interest.
Conclusion
While both examples laid out were relatively simplistic, they met the borrower and their lender’s hedging goals, limited upfront costs, retained some floating exposure, and still partially mitigated the potential future prepayment penalty.
Keep in mind, they’re based on current pricing (rather than where they actually executed) and were made possible by the fact the underlying lender was a bank, so your mileage may vary when considering options.
Pensford has been a trusted partner of real estate investors for over 15 years. Our deep industry expertise and transparency enables our clients to make informed decisions, helping to protect their investments from market volatility and ensure stability.
Interested in seeing what’s out there for one of your assets, give us a call at 704-887-9880, email us at pensfordteam@pensford.com, or respond directly to this.
