Interest rate hedging has long been a staple of floating rate commercial real estate loans. Though they are not the only solution, interest rate cap agreements have become the most popular option in the industry.

An interest rate cap is a financial product that can be most simply characterized as an insurance policy on a floating rate loan. Most floating rate CRE loans are calculated by reference to a published rate (i.e. SOFR) plus a fixed spread. If the floating rate rises above an agreed upon “strike” rate, the cap provider—usually a bank—will pay the purchaser of the cap (i.e. the borrower) or its lender the amount by which interest calculated at the floating rate exceeds interest calculated at the strike rate, effectively capping the maximum rate that a borrower will have to pay on its loan. The notional amount of the cap, the strike rate, and the term will each affect the pricing of the cap, which is paid upfront as a one-time premium to the cap provider. Caps are typically purchased through an intermediary at an auction among various banks, which can be conducted rather quickly and seamlessly, though in the post Dodd-Frank era, standard KYC is required by auction-participating banks ahead of time.