A bridge loan does not become a problem at maturity. It becomes a problem the day the rate cap runs out.
The Quiet Cliff
The deal looked stable on every quarterly update. Occupancy was holding. Rents were inching up. The trailing DSCR was on plan. And then the rate cap expired, the sponsor could not afford to replace it at the new market price, and the lender required a reserve top-up that triggered a pause in distributions. Nothing about the property had changed. The hedge had simply rolled off, and the liquidity assumption underneath was exposed.
This is the part of the deal most passive investors never see in the offering deck. The rate cap is presented as a financing detail, a one-line cost in the sources and uses, sometimes a footnote. It is treated as if it were insurance. It is not insurance. It is a temporary hedge with an expiration date, and the cost of replacing it is not under the sponsor’s control.
Question One: Does the Cap Actually Cover the Loan
The first question to ask is whether the cap actually covers the loan. There are two dimensions here, and both are routinely understated.
A rate cap can be sized to less than the full loan amount, which leaves the residual exposure floating without protection. It can also be sized for less than the full loan tenor, which is the more common gap. A three-year cap on a five-year loan is not a hedge for five years. It is a hedge for three, followed by two years of full market exposure. When a lender sees either of those structures, they typically require additional escrows or a replacement-cap covenant. Those costs are real, and they belong in the underwriting on day one, not as a surprise in year three.
A well-structured hedge covers the full loan amount and the full loan tenor. Anything short of that is a gap the lender has already priced for, and a gap the LP needs to see priced into the model too.
Question Two: What Does Replacement Actually Cost
The second question is what happens when the cap rolls off. Cap pricing is not stable. In a calm rate environment, replacement is a cost. In a volatile one, replacement is a capital event.
The premium scales with rate volatility, with the strike level relative to the forward curve, and with the remaining tenor. A cap that was a manageable line item in a quiet market can become a multiple of its original cost in a stressed one. And the sponsor has no negotiating leverage on the price. They either pay it, accept a less protective structure, or risk default.
This is the part of the underwriting that requires stress, not assumption. Asking the sponsor what the cap is projected to cost at renewal is the wrong question. The right question is what happens to distributions if the renewal cost lands at two or three times the original premium.
Question Three: What Happens at Refinance
The third question is what happens at exit. Many bridge underwrites assume a refinance into agency or bank debt at a stabilized cap rate. If that refinance loan is itself floating, a second cap may be required if not required, then highly recommended). Sponsors sometimes assume the refi will be fixed rate. Sometimes they assume cap costs will have normalized by then. Either assumption is a forecast, not a fact, and either one quietly transfers interest rate risk from the sponsor’s plan to the LP’s distributions.
A disciplined underwrite either commits to a fixed-rate refi or builds the cost of a second cap into the take-out scenario. Either choice is defensible. Silence is not.
The Discipline Behind the Hedge
Hedging interest rate risk is a discipline, not a checkbox. A sponsor who has thought carefully about it will be able to describe the cap structure in three layers: whether the cap covers the full loan and the full tenor, what the replacement cost assumption is and how it was stress-tested against a volatile rate path, and whether the exit assumes a fixed-rate refinance or a new cap with its own premium.
If a sponsor cannot describe those three layers with specificity, the LP is carrying a risk that was never priced into the return. And in a deal where the rate cap is the only thing standing between projected cash flow and a debt service shortfall, that gap matters more than the offering deck will ever suggest.
Closing Thoughts
The rate cap is one of the quietest items in the capital stack. It does not show up in the distribution forecast. It does not get highlighted on the investor call. It rarely appears in the risk slide. And yet the day it expires, every assumption sitting under it has to stand on its own.
For LPs and allocators trying to read past the projections, three diligence questions are worth asking before capital goes in. Does the cap cover the full loan amount and the full loan tenor, or is there a gap the lender has already escrowed for? What is the assumed cost to replace the cap, and how was that number stress-tested against a volatile rate path? And if the exit is a refinance rather than a sale, has the cost of a second cap, or the premium of a fixed-rate alternative, been built into the return projection?
The hedge is not the headline. But it is often the line item the deal actually depends on.
Vessi Kapoulian
Breaking down multifamily underwriting one step at a time to create educated and empowered investors
P.S. If you would like a second set of eyes on a deal or want to sharpen your underwriting through a risk lens, feel free to connect with me.
P.P.S. And if you want to go deeper into analyzing multifamily investments step-by-step, my book and the Mastering Multifamily Underwriting program walk through this process in plain English, from acquisition to exit.