A unique aspect of the commercial real estate industry over other investment sectors is the ease and availability of debt to finance transactions.
Most commercial property deals are partly funded with loans from banks or private lenders, which may offer fixed or floating (also known as variable) interest rates. Fixed rate loans have unchanging interest rates over the duration of the term, while floating rate loans have interest rates that can increase or decrease depending on market conditions.
After years of historically low interest rates following the Great Recession, rates on real estate loans began rising rapidly in the first quarter of 2022, primarily because the Federal Reserve commenced raising its benchmark federal funds rate to counter high inflation.
Commercial property loans with floating interest rates are gradually becoming more expensive as the Fed continues to raise its rates. Investors should understand how floating interest rates work, as loans with these rates have potential advantages and disadvantages.
How Floating Rate Loans Work: The Index and the Spread
Interest rates on commercial real estate loans are comprised of a nominal “spread” and an index. For floating interest rate loans, the spread is fixed, but the index is adjustable, which is why floating rates can fluctuate.
The spread is the rate above what a bank or lender would charge for additional risk, and the index is based on a benchmark lending rate. A commonly used benchmark rate for commercial real estate loans is the secured overnight financing rate (SOFR), which is based on banks’ overnight transactions in the U.S. Treasury repurchase market. SOFR replaced the widely used London Interbank Offered Rate (LIBOR).
A hypothetical rate on a $40 million acquisition loan for a multifamily property may look like this: 3.0% spread plus 30-Day SOFR of 2.0% for a total interest rate of 5.0%. If the Fed raised its federal funds rate, increasing borrowing costs for banks, it could impact the 30-Day SOFR and therefore floating interest rates on real estate transactions may increase as well. (The opposite applies when the Fed lowers its benchmark rates.)
When interest rates are expected to continue rising, a borrower with floating interest rate debt can purchase an interest rate cap to limit the interest rate on their loan from a provider or they may purchase an interest rate swap from a provider to exchange their floating interest rate with a fixed one.
What Are the Advantages and Disadvantages of Floating Rate Loans?
A major advantage of floating rate loans is they typically offer lower initial rates than fixed rate loans since the borrower is assuming additional risk with a variable rate. Furthermore, interest rates may actually decline over the course of the loan term, benefitting investors with floating rate debt.
The primary disadvantage of a floating rate loan is the potential for rates to rise, which will increase debt service payments and weaken profitability. Additionally, debt service payments are more unpredictable with floating rate loans as it’s impossible to know for certain by how much rates will increase or decrease over an entire loan term.
Loan products with shorter terms, such as bridge or construction debt, may make more sense to have floating rates, as interest rates are less likely to fluctuate significantly over a short term, and these types of loans are typically more expensive than permanent debt.
Floating interest rate loans are common tools used in commercial real estate to finance transactions. As opposed to fixed rate loans, floating rate loans have interest rates that fluctuate over the term of the loan, which could be a benefit or a risk for real estate investors, depending on the market environment.