Definition
An Interest Rate is the percentage charged by a lender on borrowed funds. In real estate investing, it represents the cost of debt capital.
Interest is typically expressed as an annual percentage of the outstanding loan balance.
How It Works
- Fixed Rate: Remains constant for the life of the loan.
- Variable (Floating) Rate: Adjusts based on a benchmark (e.g., SOFR).
- Interest-Only: Payments cover interest but not principal during a specified period.
Basic Formula
Annual Interest Payment = Loan Balance × Interest Rate
Example
A borrower takes a $10,000,000 loan at 6.5% interest.
- Annual interest = $10,000,000 × 6.5% = $650,000
If the loan amortizes, monthly payments include both interest and principal.
Why It Matters to Investors
- Cash flow impact: Higher rates increase debt service.
- Valuation impact: Rising rates often pressure cap rates and pricing.
- Refinancing risk: Rate changes affect exit assumptions.
- Return sensitivity: Small rate changes can materially affect IRR.
Interest Rate vs. Cap Rate
- Interest Rate: Cost of borrowed capital.
- Cap Rate: Market valuation metric for property income.
While distinct, they often move in relation to broader economic conditions.
Common Pitfalls
- Ignoring floating rate risk
- Underestimating refinancing exposure
- Failing to model rate sensitivity
- Overleveraging in low-rate environments