Interest Rate Cap

An interest rate cap is a contract that limits how high a floating loan rate can go. The borrower pays an upfront premium and the seller covers any interest above the strike rate. The result is a capped rate. It has nothing to do with a cap rate, which measures a property's income yield against its price.

Two numbers, two jobs. On the $500,000 example, $48,000 of scheduled rent less 5% vacancy, $6,000 of taxes, $2,500 of insurance and 18% of collected income leaves $28,892 of net operating income and a 5.78% cap rate. That figure does not change if you buy a cap on the loan. The cap changes the debt payment, so it shows up in cash flow and in cash on cash return, never in the cap rate itself. The formula is laid out in how you calculate the cap rate.

Caps are bought by borrowers with floating rate debt, usually on bridge or construction loans, and lenders often require one. The cost is an upfront premium, quoted as a percentage of the loan. Four things drive it: the strike, the term, the loan size and how much the market expects rates to move. A lower strike or a longer term costs more. Dealers price caps and floors off the forward curve for the index plus implied volatility, so quotes change daily and no public price list exists. Only a live quote tells you the real cost. Cap rates and interest rates covers the rest.