Set the strike where debt service drives DSCR down to the lender's DSCR covenant. Debt yield does not change with SOFR. Below the strike, rate movement does not threaten covenant compliance; above it, both debt service and covenant compliance are at risk. The strike should match the deal's covenant exposure, not the sponsor's stress-test instinct.
How to choose a rate-cap strike
Mistake to avoid: picking the strike based on the sponsor's stress-test instinct (e.g., 'I want protection above 6%'). The right strike is determined by the deal's specific covenant exposure, not by an absolute rate level.
Framework: calculate the SOFR level at which debt service drives DSCR down to the lender's DSCR covenant. NOI divided by loan balance is debt yield, and debt yield does not change with SOFR, so that ratio cannot produce a SOFR level. The SOFR level at the DSCR covenant is the maximum rate the loan can sustain before the borrower is at covenant risk. Set the cap strike at or just below that level to protect against covenant exposure.
Lenders typically require the strike to be at or below a defined SOFR level, often expressed as 'cap struck at a SOFR level such that all-in rate does not exceed [X%]' or 'cap struck at a level that maintains a [Y DSCR] at the strike level'. Confirm the lender's strike requirement before pricing the cap.
Sources
- Secured Overnight Financing Rate (SOFR) · Federal Reserve Bank of New York · daily
- Financial Stability Report · Board of Governors of the Federal Reserve System · 2025-11
- Semiannual Risk Perspective · Office of the Comptroller of the Currency · 2025-12