Garnet Ridge Apartments

At the April FOMC meeting, the Fed left their target rate unchanged in the 3.50% - 3.75% range as expected. The committee voted 8-4, the most dissenters in 34 years, with three voting to hold but opposing the easing bias language in the post-meeting statement, and one dissenting in favor of a cut. Inflation remains elevated, driven largely by rising global energy prices, and the Fed will continue monitoring the impact of the Middle East conflict on the global economy.

Beyond the Middle East conflict, Kevin Warsh has cleared the Senate Banking Committee on a 13-11 party line vote, the first fully partisan committee vote on a Fed chair in history, and a full Senate confirmation vote is expected the week of May 11. Contrary to tradition, Powell has stated he will remain on the Board until there is finality around the DoJ investigation.

The most recent FOMC dot plot still shows one cut in 2026 and in 2027. That said, markets are currently pricing in a ~10% chance of one 0.25% rate hike by year end. Below, we've compared current market projections to the Fed's March dot plot.

Since the underlying loan is not traditional balance sheet bank debt, Cedar Park is unable to consider other hedging options (swap, collar, hybrid) that would typically be feasible. Therefore, the hedging strategy really revolves around which cap strike to buy.

The lender required strike is believed to be around 3.50%. Since Cedar Park has the ability to purchase a higher or lower strike, all options are on the table. Below, we'll dig into the tradeoffs of purchasing higher/lower strikes and potential risks.

Cap costs can be broken down into two primary components:

• Intrinsic value – this is the present value of the projected payout based on the forward curve at the time of the purchase. In other words, it's the portion attributed to prepaid interest and lowering the strike increases the cost.
• Time value/volatility – this is driven by implied volatility and reflects the market's uncertainty around future rate movements. The portion of the cost associated with time/volatility increases with longer dated caps or environments with high levels of uncertainty (eg Iran escalation).

Markets currently project rates to average 3.76% over the next two years. A cap struck at the market average generally has the highest net cost of all the structures. This is because it's the structure with the highest level of uncertainty due to the equal chance the option will move for or against the option seller.

The further from a 3.76% strike, whether above or below, the lower the market projected net cost of the cap. While raising the strike lowers the cost, it also means purchasing protection that's not projected to pay out and meaningfully increases the borrower's exposure.

Below, we've outlined the projected payouts and portion of the cap cost attributed to each component across a range of structures.

A more efficient use of funds is arguably achieved by going deeper in-the-money (ITM) with the strike.

• The 3.00% cap costs $1.75mm and the market projects all but $254k (14.5%) of the upfront cost to be recouped
• The 3.50% cap costs $1.00mm but the market projects only $513k to be recouped. In other words, $487k of the upfront cost (48.7%) is attributed to volatility

If Cedar Park is seeking the most efficient hedge structure, then purchasing a lower strike cap could be worth considering. This is a perspective we often see other institutional borrowers use when thinking through hedge strategies.

• If rates remain at or above 3.50% for the entire cap term, purchasing a 3.00% strike instead of 3.50% will save $233k
  • This is the projected net cost difference between the 3.00% and 3.50% strikes
• The risk of going deeper ITM is that interest is front loaded and won't be recouped if rates end up averaging below expectations
  • Rates must go below 3.50% before purchasing the higher strike begins to provide a benefit in this scenario
  • For context, rates would need to average <3.37% over the entire hedge term in order for the 3.50% strike to save more than $233k

The loan documents permit the purchase of a cap above the required strike, but the borrower must post a rate cap reserve. In short, here are the mechanics:

• The reserve amounts to [loan amount * (purchased strike – required strike) * (term)]
• Each month, the deposit is applied to the loan payment if SOFR exceeds the required strike, and any excess funds for that interest period are returned to the borrower

The requirement to post a reserve deposit negates the benefit of a higher strike due to the restrictive upfront burden.

Volatility is an asset class that's traded like stocks or bonds. Since implied volatility drives a portion of a cap cost, we thought it was worth taking a closer look at where it stands today in the wake of the Iran conflict.

The graph below is of the “MOVE” index, a measure of bond market implied volatility calculated and published by BofA. While it doesn't match 1-1 for each cap structure, it's an excellent general indicator and can be found on Google.

• Implied volatility trended lower throughout much of 2025 and reached nearly 5 year lows in January, coming in at 55.8
• At the end of February, the MOVE index was 73.4, spiked to 115 in late March, and has since returned to 72.2

While volatility is still elevated relative to the 2026 low, it quickly normalized and still remains below levels seen much of 2022-2025.

Given the upfront cost burden associated with a higher cap strike, Cedar Park will likely want to purchase the lender required strike to ensure the lowest upfront cost.

If the desire is to not just satisfy the hedge requirement, but to use funds more efficiently, Cedar Park might consider purchasing a lower strike cap.

The intent of this analysis is meant to provide a basis for dialogue. With input from Cedar Park, we are happy to provide additional analysis and thoughts to help dial in on the hedge strategy that makes the most sense.