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Fixed Vs Floating Rate Debt
December 27, 2020
Back in early 2018 we all thought interest rates were rising and so everybody thought they were a genius when they were talking about locking in a fixed rate loan at the time’s “low” interest rates for 10 years. Additionally, some investors were very hesitant about bridge loans because they are both short-term in maturity and they usually have a floating interest rate, so you were subject to interest rate risk as well. However, as you may know, interest rates quickly changed course in 2019 and began a course downward and then accelerated downward due to the onset of the coronavirus pandemic. Looking back, investors who were thrilled to lock in a fixed rate at 4.5% or 4% could be floating at less than 3% today. That is the magic of floating rate debt.
Floating rate debt takes the guess work out of interest rates and exposes you to the risks and rewards of interest rate changes. While a fixed rate may help you sleep better at night, it limits your upside and flexibility in the situation where rates move lower. From a numbers standpoint, the research shows you actually pay the least amount of interest when you float rather than fix over almost any period of time.
An interesting point to consider is whether it makes more sense to fix or float in a rising rate environment as well as in a lowering rate environment. You may find the answer surprising since your initial reaction might be to go for a fixed interest rate in a rising rate environment since you lock in the low rate today while rates rise over time. However, the reality is that in a rising rate environment, the market is already pricing in higher yields (and usually overshoots the actual increase in LIBOR). Rather than locking in the already higher rate, it is instead possible to gradually float higher in a rising rate environment and actually save money in the end.
In a falling rate environment, again it may be tempting to go for a fixed rate since fixed rates are sometimes actually less than floating rates at closing in this type of environment so you’re locking in day one savings. However, this is an indication that floating rates are soon to follow and they usually decline further than the cost of fixed rate debt, thus benefiting those with floating rate loans. In early 2020, we were able to observe this phenomenon as the 10-year treasury made its move downward much faster since it is controlled by market perception while the short end of the curve, namely LIBOR, declined gradually based on monetary policy set by the Federal Reserve.
For those concerned about the potential for unbounded interest rate risk on a floating rate loan, the solution is an interest rate cap, which is actually a mandatory hedging product that lenders require borrowers to purchase. Interest rate caps literally cap your interest rate exposure up to a certain level, essentially turning your floating rate loan into a fixed rate loan if the cap or ceiling is reached. Watch this quick video to learn more about rate caps.
The final but potentially most important point about fixed rate versus floating rate loans are the prepayment penalties associated with each type of loan. A fixed rate loan often has a yield maintenance/defeasance prepayment penalty. There are complex calculations which can be extremely costly to the borrower depending on prevailing market interest rates and the term remaining on the loan. Because of this, flexibility such as the ability to opportunistically sell early in the loan term is complicated since the property will have to be sold subject to an assumption of the existing financing. Fixed rate loans may also have a “step-down” prepayment structure which is 2 not as bad as yield maintenance, but the lender makes up for this with an increased interest rate. Meanwhile, floating rate loans typically have a very straightforward and economical prepayment penalty of 1% of the loan amount irrespective of term remaining on the loan. For investors who are less concerned about interest rate fluctuations and are more concerned with being able to opportunistically sell or refinance their asset with minimal penalty, floating rate loans most likely the best option. Floating rate loans can be further optimized with the sophisticated use of interest rate caps which can have a strike (interest rate ceiling) as close to the in-place rate as needed in order to protect future cash flows.
If you’re interested in learning more about our investment offerings or would like help in securing the best debt structure for your next deal, please feel free to reach out to me directly.