In a climate of rising rates, IRCs provide owners and borrowers with stability, says Parkview Financial’s Vishal Hotchandani.

Vishal Hotchandani

Over the past year, developers have faced rising construction costs due to inflation, disruptions in the global supply chain, demand for construction and higher labor costs.

CBRE Construction Cost Index predicts growth of 14.1 percent annually until the end of 20221. While the Federal Reserve’s policy of raising the Fed funds rate and quantitative tightening to squeeze inflation out of the U.S. economy should eventually provide some relief to builders, in the short term it will negatively impact their profitability by increasing the cost of financing. It is not surprising that in recent months, borrowers who are going to start construction, turn to loans at a fixed rate.

Almost all private lenders use leverage themselves—at the extreme to increase returns for investors and, at the modest end, to manage the fund’s cash flow. Providing a borrower with a fixed rate loan at a time when the borrower’s equity value of the loan increases will adversely affect the lender’s return to its investors. As responsible fiduciaries, fund managers are unlikely to grant requests for fixed rate loans. So those who take out floating rate loans but are looking for stability in terms of interest payments should look to the derivatives markets and consider buying an interest rate cap (IRC).

Image by Tumisu from Pixabay

In short, an IRC is an insurance policy. In exchange for a single premium payment, the IRC provider promises to pay additional interest if the index on which the floating rate loan is based increases. The main terms to know when working with IRC are conditional terms, term and strike frequency2 and the cost can be estimated using an online calculator.

For clarity, consider interest-only financing on the entire $30 million loan amount (notional) due in two years (term) and offered at 1-month SOFR (1MTS) + 6 percent (spread). Also assume that the strike of IRC and 1MTS at the close is 3 percent. The value of such an IRC today would be $821,000 (2.74 percent of the notional)3. The table below shows the lender’s projected monthly interest payments based on the 1MTS forward curve4 and is broken down by the amount paid by the borrower and the IRC provider.

Vishal Hotchandan – Senior Loan Originator, Parkview Financial.

Notes: (1) Most floating-rate, interest-only construction lenders charge interest only on the dollars received, which means the total interest cost of the example loan will be much less. IRC prices for this type of product will also be lower, but not possible with any of the available online calculators; (2) the total volume of the IRC provider is independent of the spread, and 6 percent was used for illustrative purposes.

Source link