When a rate cap expires mid-bridge on a commercial development deal, who actually holds the exposure
A rate cap is bought at closing to protect the floating rate on a bridge loan, and the premium gets priced into the equity raise like a known cost. What the model often misses is the renewal. Caps are bought for a term, frequently one or two years, and if the business plan runs long, which ground-up deals do more than any other category, the cap expires and the borrower is unprotected on a floating index at whatever the market is doing at that moment. Renewing a cap mid-loan costs multiples of what the original cap cost if rates have moved against you, and some lenders require renewal as a loan covenant, meaning failure to renew is a technical default. So the exposure is not abstract and it does not sit with the lender. It sits with the sponsor and flows straight through to LP returns, because the extra carry to cover an unhedged rate environment comes out of the same pool. The deal to examine is any ground-up project that priced a cap at, say, 40 basis points of loan balance in a low-rate environment, now facing a renewal at 200 basis points or more, with a construction delay already having consumed eight months of the original term. That renewal cost can turn a projected distribution into a capital call. What I am trying to work out is how sponsors are handling this in their current waterfall language, specifically whether the cap renewal cost gets treated as a project expense that reduces preferred returns or whether it sits below the preferred and compresses the sponsor's carry first. What does your LP agreement actually say about that line item?
