Definition
A floating rate loan (also called a variable rate loan) is a loan where the interest rate changes over time based on a reference index (commonly SOFR) plus a lender spread. As the index moves, the borrower’s interest rate—and therefore debt service—moves with it.
How It Works
Floating rate loans are usually quoted as Index + Spread. The lender resets the rate on a schedule (often monthly or quarterly). Many loans include a floor (minimum index) and may have contractual caps (less common) or require the borrower to purchase an interest rate cap.
Common formula
- All-in Interest Rate = Reference Index (e.g., SOFR) + Lender Spread
Why It Matters
Floating rate debt can improve flexibility (especially for short-term holds), but it introduces interest-rate risk. If rates rise faster than NOI, the deal’s cash flow can compress and DSCR can deteriorate. In stressed markets, floating-rate loans can force capital calls, trigger covenants, or make refinancing difficult.
Typical Uses in Real Estate
- Bridge loans: short-term financing for value-add or transitional properties.
- Construction loans: rates float during the construction/draw period.
- Repositioning: when the business plan expects NOI growth before stabilization/refi.
- Near-term exit: when you plan to sell or refinance into long-term fixed debt.
Interest Rate Caps and Hedging
Borrowers often manage rate risk using an interest rate cap, which limits how high the index portion of the rate can rise above a specified level. Caps reduce tail risk but add an upfront cost. Some borrowers use swaps or other hedges, depending on the loan and lender requirements.
- Rate cap: insurance against the index rising above a strike rate.
- Rate floor: minimum index level (can keep rates from falling as much when markets drop).
- Hedge mismatch risk: cap term, notional amount, and extension options must match the loan.
Floating vs. Fixed Rate
The key difference is payment certainty. Fixed-rate loans give predictable debt service, while floating-rate loans shift interest-rate risk to the borrower (unless hedged).
- Floating rate: more flexibility, more rate risk; often paired with caps.
- Fixed rate: more stability, often less prepay flexibility depending on structure.
Example
A bridge loan is quoted at SOFR + 3.25%. If SOFR is 5.00%, the all-in rate is:
- All-in Rate = 5.00% + 3.25% = 8.25%
If SOFR rises to 6.00%, the all-in rate becomes 9.25%, increasing debt service and reducing cash flow unless NOI has grown or the borrower has a cap limiting the increase.
Common Pitfalls
- Underestimating rate volatility: small moves in the index can swing returns materially.
- Not buying adequate protection: a cheap cap with a high strike may not protect DSCR.
- Ignoring floors: index floors prevent rates from dropping as much when the market falls.
- Extension risk: loan extensions may require DSCR tests, paydowns, or new cap purchases.
- Mismatch with business plan: floating-rate debt on a long hold increases uncertainty.
- Refi cliff: higher rates can reduce permanent loan proceeds when you try to refinance.