SOFR, Swaps, and Caps: How to Hedge Floating-Rate CRE Debt

Interest rate hedging in CRE comes down to one structural choice: a cap is insurance you buy, a swap is an obligation you owe. Both convert the risk on a floating-rate loan indexed to SOFR, but they behave in opposite directions when rates move against your expectation. A cap costs cash upfront and does nothing but protect you above a strike. A swap costs nothing upfront and fixes your rate, but it can turn into a liability you pay to escape. Choosing wrong does not show up until you need to sell, refinance, or renew, and by then the cost is fixed.

The thesis: the hedge is not a formality the lender requires and you forget. It is a position with its own P&L, and the borrower who treats a cap as a sunk fee or a swap as free financing has mispriced the risk they thought they hedged.

Key Takeaways

SOFR, the Secured Overnight Financing Rate, is the benchmark that replaced LIBOR for non-agency CRE floating-rate debt. It sat at 3.66 percent as of July 1, 2026 per the New York Fed and published data.
An interest rate cap is a one-way option: you pay a premium upfront, and the seller pays you when SOFR exceeds your strike. Your downside is capped at the premium.
An interest rate swap is a bilateral obligation: no upfront cost, a fixed rate, but you owe breakage if you exit early when rates have fallen.
Cap renewal is the trap of this cycle. Chatham Financial data shows caps bought in 2021 renewed in 2024 to 2026 at 1.5 to 2.5 percent of notional, roughly 5 to 10 times the original cost.
Lenders require a hedge to protect their collateral and preserve minimum DSCR, but they do not choose the instrument that is best for your equity. You do.

What is the difference between an interest rate cap and a swap?

An interest rate cap is an option you buy for an upfront premium that pays you when SOFR rises above a set strike, protecting the loan while letting you keep the benefit if rates fall. A swap is a contract that fixes your rate entirely with no upfront cost, but obligates you both ways, so you pay breakage if you unwind it when rates have dropped.

The functional split is asymmetry versus symmetry. A cap establishes a known worst case while preserving the upside of a falling rate below the strike. A swap creates a fixed-rate profile: certainty in both directions, which means you forgo the benefit of falling rates and you owe a settlement if you break the swap early. Chatham Financial frames swap breakage as the floating-rate parallel to defeasance or yield maintenance on fixed-rate CMBS, though it is generally less punitive because breakage compares swap rate to swap rate rather than a full loan coupon to a Treasury yield.

Feature	Interest rate cap	Interest rate swap
Upfront cost	Premium paid at close	None
Rate outcome	Worst case fixed, upside kept	Fully fixed, no upside
Early exit	Walk away, no penalty	Breakage owed if rates fell
Obligation	One-way (option)	Two-way (bilateral)
Best when	Rates may fall, or short hold	Long hold, certainty prized

See the SOFR, interest rate cap, and interest rate swap glossary entries for the full mechanics.

How much does a SOFR cap actually cost?

A SOFR cap costs a one-time premium set by the strike, the notional, the term, and the market's forward view of rates. Q1 2026 pricing on a 50 million dollar notional, three-year cap ran roughly 1.0 to 1.5 million dollars, or 2.0 to 3.0 percent of notional, at a 5.00 percent strike, per Chatham Financial cap data. A lower strike costs more; a higher strike costs less.

The relationship is intuitive once you see it. The strike is your deductible. A 4.50 percent strike on that same 50 million dollar, three-year cap ran roughly 1.5 to 2.0 million dollars because it starts paying sooner, while a 5.50 percent strike ran roughly 750,000 dollars to 1.0 million because it starts paying later. You are buying protection, and cheaper protection kicks in further out of the money.

The cost that surprises borrowers is renewal. Many floating-rate loans require the cap to be maintained for the full term, so a three-year cap on a five-year loan must be replaced. Chatham Financial reported that sponsors who bought caps cheaply in 2021 and needed renewal caps in 2024 to 2026, with strikes set high enough to keep debt-yield underwriting intact, paid renewal premiums of 1.5 to 2.5 percent of notional. That is roughly 5 to 10 times the original cost. A hedge that looked like a rounding error at closing became a capital call two years later.

The expert-voice line worth keeping: a cap is not a fee you pay once, it is a position you re-underwrite every time it expires, and the second premium is the one that hurts.

When should a borrower choose a swap over a cap?

A borrower should choose a swap over a cap when the hold is long, certainty is worth more than flexibility, and there is low probability of an early sale or refinance that would trigger breakage. The swap fixes the rate with no upfront cash, which frees capital at closing, but it converts the hedge into a bilateral obligation that can become a liability.

The deciding variable is your exit. A swap saves the upfront premium and delivers full payment certainty, which suits a borrower planning to hold through the loan term. But if SOFR falls and you need to sell or refinance early, you owe breakage: the present value of the difference between your fixed rate and the market. Chatham Financial notes this breakage is generally less punitive than a fixed-rate loan's yield maintenance or defeasance, because it lacks spread maintenance, but it is real cash owed at the worst possible time, when rates have dropped and you want out.

Worked comparison on a 50 million dollar, three-year hedge. The cap costs, say, 1.25 million dollars at a 5.00 percent strike, and that is the entire downside: if SOFR stays low, you overpaid for insurance you did not use, and if it spikes, you are protected and you keep any benefit below the strike. The swap costs nothing at close and fixes your rate, but if you sell in year two after SOFR has fallen a point, the breakage could easily exceed the cap premium you avoided. The cap caps your loss at the premium. The swap does not cap anything; it trades premium risk for exit risk. Which risk you would rather own is the whole decision. See the related post on why debt yield beats DSCR for how lenders use these hedges to protect the debt-yield test.

Frequently Asked Questions

Why do lenders require an interest rate cap?

Lenders require a cap to protect their collateral and to ensure the borrower can still meet minimum DSCR and debt-yield thresholds if rates rise. The cap guarantees the loan's interest expense has a ceiling, which protects the lender's underwriting. The lender's requirement protects the loan, not necessarily the borrower's equity, which is why the borrower should still evaluate the instrument on its own terms.

What is SOFR and how does it differ from LIBOR?

SOFR, the Secured Overnight Financing Rate, is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities, published each business day by the New York Fed. It replaced LIBOR as the benchmark for non-agency CRE floating-rate debt. Unlike LIBOR, SOFR is based on observed transactions rather than bank estimates, which makes it harder to manipulate.

Is swap breakage as costly as defeasance?

Generally no. Swap breakage is the floating-rate parallel to defeasance or yield maintenance, but it is usually less punitive because breakage compares one swap rate to another, without the spread maintenance embedded in a fixed-rate loan's prepayment penalty. It is still a real cost owed on early exit when rates have fallen, and it should be modeled before entering the swap.

Conclusion

A cap is insurance you buy; a swap is an obligation you owe. That asymmetry is the entire framework for interest rate hedging in CRE. The cap caps your loss at the premium and preserves your upside, at the price of cash today and a renewal that may cost many times more. The swap costs nothing upfront and delivers certainty, at the price of an exit penalty that lands exactly when rates have moved against you. Neither is a formality, and the lender who requires the hedge is protecting the loan, not your equity. For the operator, the discipline is to price the hedge as its own position: model the renewal, model the breakage, and choose the instrument whose worst case you can actually live with. The hedge you forget is the one that surprises you.