Definition
A variable-rate loan (also called a floating-rate loan) is a loan whose interest rate changes over time based on a reference benchmark (an index) plus a lender spread. Because the rate resets, the borrower’s monthly interest expense and debt service can rise or fall, which directly impacts cash flow and underwriting.
How the Rate Is Set
Most floating-rate loans are structured as:
- All-in Rate = Index + Spread
Key components
- Index: a market benchmark that moves with short-term rates (reset frequency varies).
- Spread: lender’s fixed margin added to the index based on risk, leverage, and structure.
- Reset frequency: how often the index is applied (commonly monthly or quarterly).
- Interest-only vs. amortizing: many variable-rate loans are interest-only during the term.
Caps, Floors, and Hedging
Floating-rate debt introduces interest-rate risk, so lenders and borrowers often use:
- Rate cap: limits the maximum index rate (or the all-in rate, depending on structure) for a period.
- Floor: sets a minimum index rate so the lender’s yield doesn’t fall below a threshold.
- Swap: converts floating payments into fixed payments (effectively “fixing†the rate).
Underwriting should treat hedging costs (cap premium or swap costs) as part of the financing package.
Why Investors Use Variable-Rate Loans
- Flexibility: often includes shorter terms, extension options, and easier prepayment.
- Bridge execution: common for value-add, lease-up, or transitional assets.
- Potentially lower initial rate: in some rate environments, floating can start lower than fixed.
- Match the business plan: short-term debt can align with a 12–36 month repositioning plan.
Key Risks
- Rate shock: higher index rates increase debt service and reduce cash flow.
- DSCR squeeze: rising payments can break covenants or reduce distributions.
- Refinance risk: if rates rise or cap rates expand, takeout financing may be harder.
- Extension risk: extensions often require fees, updated covenants, and proof of progress.
- Hedge mismatch: cap not sized for extension period, or strike too high to protect cash flow.
How Investors Underwrite Variable-Rate Debt
- Base case + rate shocks: test +100 bps, +200 bps, +300 bps and evaluate DSCR and cash flow.
- Cap protection: model the cap strike, term, and extension coverage (if applicable).
- Debt yield / DSCR covenants: confirm compliance under stress and during renovation downtime.
- Exit realism: validate takeout assumptions (stabilized NOI, terminal cap rate, permanent loan sizing).
- Reserves: carry adequate operating and interest reserves for volatility and lease-up friction.
Example
A bridge loan is priced at Index + 3.25% and resets monthly. If the index is 4.75%, the all-in rate is:
- All-in Rate = 4.75% + 3.25% = 8.00%
If the index rises to 6.25% at the next reset, the rate becomes 9.50%. That increase can materially reduce cash flow and may require either a higher NOI, lower leverage, a hedging structure, or additional reserves to stay within a safe underwriting box.
Common Pitfalls
- Ignoring the floor: assuming rates can fall below a contractual minimum.
- Cap strike too high: “having a cap†doesn’t mean you’re protected at a workable payment level.
- Extension not hedged: cap expires before extension periods, creating uncovered rate exposure.
- Underwriting off teaser rates: using today’s index without forward-looking stress tests.
- Not modeling IO correctly: payment profile can change materially if amortization kicks in.