Financing Scenarios & Derivatives

You arrive at work the next morning. Shortly after, your boss comes over, thanks you for the email last night, and mentions they spoke to the head of the Debt Capital Markets (DCM) team — they have some leverage metrics they want you to run.

Your boss tells you they think a rate cap is going to be too expensive, but they want to see the impact to the levered IRR relative to an interest rate swap, a rate cap, and going completely unhedged based on the forward SOFR curve. The loan duration from DCM is a 5-year term, so you'll need to make a refinancing assumption. Your boss asks if you can have this done by end of day.

You move the rate cap Excel and the downloaded forward SOFR curve into your existing model. You build a new financing tab, enter all the debt assumptions, and reference your unlevered cash flows. As you work through the hedges and refinancing you get a little confused — fortunately the Senior Associate is back.

The Senior Associate reminds you to include financing and legal costs (25 bps for initial loan and refi, 5 bps for each hedge), and to solve for the refi loan amount by capping the forward NOI at the terminal cap rate rather than using purchase price. For the swap: you're always paying the fixed rate, just making or receiving a payment based on where SOFR lands. For the cap: you owe nothing above the strike — the spread isn't part of the hedge calculation.

You spend the rest of the day building it out and send your boss the levered IRR, multiple, and profit for all three scenarios right around 5pm.