When Should I Extend My Cap?

Overview

Many borrowers with upcoming hedge maturities wonder if they should trade today or wait until closer to maturity. Several factors impact whether buying today or waiting is more beneficial. These include:

• Market rate expectations
• Where the replacement cap strike is set
• Desire to improve cashflow using existing replacement cap escrows – see our resource Cut Cap Escrows in Half for more on this one

Caps costs are driven by (i) rate expectations, and (ii) time/volatility. Rate expectations are another way of saying the forward curve, which drives the “projected payout” or “intrinsic value” of a cap.

In a typical rate environment, the cost of a cap increases exponentially with term. Therefore, when a borrower compares the cost of buying early to the projected cost if they wait, the difference is generally material, and waiting to buy would be more beneficial if rates don’t spike.

We wrote about this concept in our previous resource Time Value Impact on Cap Pricing. In this resource, we look at how the rule of thumb is still true today, but not for every cap structure.

Buy vs Wait – 2018 Example

Let’s look at a historical example from 4/1/2018. Assume a borrower had a $25mm cap in place through 10/1/2018 and was considering buying the extension six months early.

$25mm

10/1/2018 – 10/1/2019

3.00% strike

1ML

Cost as of 4/1/2018 - $25,000

Holding rates and volatility constant, the market projected cost on 10/1/2018 was $17,000

• In other words, all else equal, waiting six months to buy would save $8k or 32% of the cost

With the benefit of hindsight, we can look back and see that the cap extension on 10/1/2018 was actually $21,000. This is $4k less than the cost of buying early, despite 1 year rates rising 0.24% between October and April. Those were the days!

One key difference between this scenario and now is that a 3.00% strike is considered an in-the-money (ITM) cap today whereas it was considered an out of the money (OTM), or higher strike, back in 2018. The outcome of waiting to buy today can change depending on where the strike is set.

Buy vs Wait – Today

Let’s look at a new but similar example. Assume a borrower has a $25mm cap in place through 4/1/2024 and is considering buying the one year extension today.

$25mm

4/1/2024 – 4/1/2025

3.00% strike

Term SOFR

Cost as of 9/13/2023 - $501,000

Holding rates and volatility constant, the market projected cost on 4/1/2024 is $498,000. In other words, the cost of buying in the future is projected to essentially be the same.

Since we’re “holding rates and volatility constant”, it’s a bit counterintuitive. Let’s look at a higher strike to see what happens.

$25mm

4/1/2024 – 4/1/2025

5.00% strike

Term SOFR

Cost as of 9/13/2023 - $142,000

Holding rates and volatility constant, the market projected cost on 4/1/2024 is $88,000. Like our 2018 cap example, waiting to buy is expected to result in more material savings.

Why’s there a difference in outcome when the strike changes?

• The cost of a lower ITM strike cap (eg 3.00% today) is primarily driven by market rate expectations (projected payout). Cap premiums are a PV number, and since the 3.00% cap cost is primarily prepaid interest, buying early means that prepaid interest is discounted over a longer period making the cost appear lower.
  • While there’s some time/volatility premium to bleed off, it’s generally a much smaller portion of the cap cost, and the impact from the time value of money is more meaningful. In other words, holding rates constant and buying in the future means the cost is often projected to be the same if not slightly more.
• The cost of a higher OTM strike cap (eg 5.00%+) is largely attributed to time/volatility, since higher strikes have less (if any) projected payout.
  • While the same PV factor comes into play, the upfront cost is much smaller, so the effect of discounting has a smaller impact, making the decreasing volatility premium the main driver. Since higher strikes cap costs are primarily driven by time/volatility, letting time pass before buying decreases the cost (all else equal).

What does this mean for me today?

If your replacement cap has a lower/ITM strike, since the cap cost is primarily prepaid interest, waiting to buy may only result in material savings if rates fall between now and the hedge maturity. If rates rise, the cap cost will likely increase in tandem.

If your replacement cap has a higher/OTM strike, waiting to buy could result in savings from the time/volatility premium bleeding off. In some cases, this is true even if rates rise between now and the existing caps maturity.

If you’d like to speak with an expert or would like assistance thinking through strategy for your upcoming hedge maturities, reach out to pensfordteam@pensford.com or 704-887-9880.