Fixed Rate vs. Floating Rate Loans – What Real Estate Investors Need To Know

If you’re financing a commercial real estate deal with debt, one of the most important decisions you’ll make is whether to go with a fixed-rate loan or a floating-rate loan.

While this might seem like a relatively small decision in the grand scheme of things, this can have a huge impact on the performance of a deal, and this post breaks down the main things you need to know about both floating and fixed-rate loans, and when (and why) it might make sense to use each.

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Fixed Rate Loans

To start with fixed-rate loans first, these loans will have the same interest rate throughout the entire loan term, and whatever rate you lock in at the time of closing is what you’ll continue to pay until that loan matures.

Fixed-rate loans are great options for investors who believe interest rates will increase over the loan term, but these are also great options for risk-averse investors who are willing to sacrifice maximizing returns for the sake of capping their downside.

Fixed-rate loans give a borrower certainty about their monthly debt service obligations, regardless of where interest rates go during the loan term. This is often a preferable option for investors acquiring stabilized assets with a long-term hold horizon, with the primary goal of generating predictable monthly income.

How Fixed Rate Loans Are Priced

Fixed-rate loans in the US are typically priced based on the equivalent term US Treasury yield, plus an additional spread above that. This means that a 5-year fixed-rate loan would be priced based on the 5-year US Treasury yield at the time the loan is originated, plus an additional yield to the lender based on risk and volatility.

Prepayment Penalties

The main issue with fixed-rate loans is that these can be extremely inflexible when it comes to prepayment. Fixed-rate loans will often include major penalties if the loan is paid before the maturity date, and in some cases, there may also be what are referred to as “lockout periods” where the loan can’t be prepaid at all.

These things can make it difficult (or impossible) to sell or refinance more than about a year before the loan is scheduled to mature, which can create serious issues if the borrower wants to take advantage of peak market pricing during the loan term, or significantly lower interest rates that could materially increase cash flow.

The Bottom Line on Fixed Rate Loans

Even with these downsides, fixed-rate loans can be great options for investors who plan to hold their properties for a long period of time, and especially investors who are looking for certainty in their loan payments throughout the entire loan term.

Floating Rate Loans

On the other side of the spectrum, we have floating-rate loans, which have an interest rate that’s variable throughout the loan term and typically changes on a monthly basis.

These types of loans tend to be great options for investors with a high risk tolerance who believe that interest rates will fall over the loan term, and these are also great for investors who need to maximize prepayment flexibility for shorter-term holds.

And unlike fixed-rate loans, most floating-rate loans don’t come with major prepayment penalties. This makes these really popular options for major renovation projects, ground-up development projects, or any scenario where an investor plans to sell or refinance in just a few years.

How Floating Rate Loans Are Priced

Floating-rate loans in the US are typically priced based on the 1-month term Secured Overnight Financing Rate (SOFR), plus a spread for the lender of anywhere between ~250-450 basis points, depending on the deal.

This means that if the 1-month SOFR is 4.0% at the time of closing and your spread is 300 basis points, your all-in interest rate on the loan to start would be 7.0%. But if the 1-month SOFR drops to 3.0% two years from now, the all-in interest rate at that time would drop to just 6.0%.

Interest Rate Caps: Insurance Against Rising Rates

Even though investors using floating-rate loans are typically willing to take on risk, they’ll also often take steps to protect against a major downside scenario. This is where interest rate caps start to come into play.

What Is an Interest Rate Cap?

An interest rate cap is essentially an insurance policy on a loan, where a borrower pays an up-front fee to a third party. In exchange for that fee, the rate cap provider will pay any overage in monthly debt service if rates go above what’s referred to as a strike rate.

How Strike Rates Work

A strike rate represents the maximum interest rate that a borrower is responsible for, even if rates go above this amount.

This means that on an interest-only, $1 million loan with a floating interest rate priced at 1-month SOFR plus 300 basis points, and a rate cap with a strike rate of 6.0%, even if SOFR ends up jumping up to 9.0% during that term, the borrower would only be responsible for that first $7,500 per month in total debt service. In these situations, the borrower would still need to pay the lender the full $10,000 monthly debt service amount up front, but the cap provider would then have to come in and reimburse the borrower for the $2,500 overage above that strike rate.

What Impacts Cap Pricing

Just like any other insurance product, these caps aren’t free. A few different things can impact the cost of these in the market, including:

1. The Strike Rate: In general, a cap with a lower strike rate will be more expensive than a cap with a higher strike rate, all else being equal. A lower strike rate will increase the likelihood that the cap provider will ultimately have to make payments at some point throughout the term.

2. The Notional: This is the loan amount the cap applies to. A higher notional is typically more expensive than a lower notional, since a higher notional results in more monthly debt service that the cap provider might be responsible for.

3. The Term: How long the cap applies will also impact pricing, with a longer term being more expensive than a shorter term.

4. Market Volatility: Volatility in the capital markets can also play a huge role here, with more volatility in interest rates resulting in more expensive rate caps.

Interest Rate Floors: Protection for Lenders

In addition to interest rate caps, just like borrowers will try to protect their downside, lenders will also try to protect their downside through what are referred to as interest rate floors. These set a minimum interest rate on a loan, even if the index rate ends up falling beneath that.

This means that again, on an interest-only, $1 million loan with a floating interest rate priced at 1-month SOFR plus 300 basis points and a rate floor of 3.0%, even if SOFR ends up falling to 2.0% during the term, the borrower would still be responsible for all-in payments of $5,000 per month.

Making the Right Choice

In many cases, investors will run both floating and fixed-rate loan scenarios through a detailed financial model, to see the impacts of each on cash flows and returns.

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