What strike do you think makes sense to buy?
The age-old question! The standard answer is that the right strategy differs with each client, their outlook, the asset, and market, so it’s challenging to give a definitive answer. However, if you’re asking for my input, I think around 4.00% is interesting today.
Why?
The current forward curve is quite flat, with SOFR dipping below 4.00% later this year and leveling off around 3.90% for the foreseeable future. Due to this, mid-market swap rates are around 4.00% across all tenors, and in fancy trader jargon, that means 4.00% strikes are at-the-money (ATM).
Buying an ATM strike is something we discuss in all environments, but the flat curve is what makes it stand out.
In a typical rate environment (rising) an ATM strike is projected to spend the first half of its life above the forward curve and the second half below. Said another way, rates have to rise a lot during the earlier portion of the cap before reaching the strike but you’re front loading (prepaying) interest in the back half. To help illustrate the concept, below is a graph comparing a forward curve from Jan 2022 to the respective strike.
Next, I’ve outlined the current forward curve and ATM strike. As you’ll see, the first six months are projected to pay out, but the remainder of the cap is not. In other words, you’re obtaining tight protection over the term while the only frontloaded interest is in the earlier months (when there’s arguably the most certainty).
How do 4.00% caps price?
Below, I’ve included a table comparing 4.00% caps across a few terms. A couple of higher strikes were included for reference.
Projected performance
If rates follow expectations, only a small portion of the upfront premium is recouped. See below for those scenarios.
There are any number of scenarios we could run, but if the market just backed out the ~1.5 cuts currently priced in (SOFR remains at 4.31%), the cap pays out much more meaningfully.
If the Fed cuts rates quicker than expected, then the cap would certainly lose meaningful value. On the flip side, if the Fed continues to hold rates unchanged or even hikes again, the cap kicks in right away as seen above.
What else?
With fixed and floating rate options pricing much more closely today, one benefit of buying an ATM strike is that you’re putting a ceiling near the fixed rate equivalent but (i) retaining prepay flexibility, and (ii) retaining the ability to float lower.
And since we recently talked about Hybrid Hedging Strategies, if your lender is a bank, swapping half and capping the other half is another simple way of balancing cost and protection.
Find this interesting or want to consider different options for assets in your portfolio? Let’s talk! Give us a call at 704-887-9880 or email us at pensfordteam@pensford.com.
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.
