By Brian Holstein

Coke or Pepsi? Stripes or Solids? Apple or Android? Ohhh, the agonizing decisions we humans are forced to make on a daily basis! What if I told you that choosing between a fixed-rate loan and a floating-rate loan could make or break an otherwise successful real estate investment? Given how often this topic arises and how long the deliberation can last, I will guess that most real estate professionals reading this article would agree with the above statement. Below is a primer on the difference between fixed-rate loans and floating-rate loans and the pros and cons of each option.

Interest Rates

Fixed-rate loans typically carry a lower interest rate than their floating-rate counterparts. The general reasoning is that floating-rate loans tend to be secured by riskier assets as they are the main tool for financing “value-add” transitional real estate projects. They also are usually higher in leverage by 5-10 percentage points. There are, of course, always exceptions to this rule. Some borrowers prefer the prepayment flexibility of floating rate loans and will take on the associated interest rate risk to keep their stabilized real estate investments as liquid as possible and eliminate the potential for large amounts of “trapped equity” that can accumulate over a 5 or 10 year period. A lower leverage floating-rate loan on a stabilized asset can easily carry a lower interest rate than a fixed-rate loan of similar profile, but given how historically low interest rates are at the moment, most borrowers will still opt for a fixed-rate loan in order to lock in current rates for a longer period of time. In a higher interest rate environment, the opposite tends to be true.

Leverage

All this being equal, floating-rate lenders offer higher leverage loans than fixed-rate lenders. The reason floating-rate loans are characteristically available at higher leverage levels than permanent, fixed-rate loans is the value-add nature of the real estate securing the loan. Projected “exit” LTV is a major focus for floating-rate lenders and the greater the value-add story, the easier it is to push the leverage without inviting a maturity default. The exception to this rule is the case of fixed-rate “stretch seniors” and fixed-rate loans topped off with mezzanine loans. Fixed-rate stretch seniors and mezzanine loans can certainly be used to capitalize repositions, but often times they are used simply because they are readily available and almost always cheaper than equity.

Term

Most fixed-rate loans have a term of 5, 7 or 10 years. Floating-rate loans are shorter in duration, offering a 2 or 3 year initial term and extension options that take the final maturity out to 5 years.

Amortization

Floating-rate loans tend to carry a higher interest rate, but make up for that by requiring interest-only payments, although sometimes the extension options will trigger minimal amortization. Fixed-rate hotel loans usually amortize over a 25 or 30 year schedule, with partial interest-only available on reasonable leverage loans and full-term interest-only available on low leverage loans. Amortization is a deleveraging tool that is unnecessary for most floating-rate loans as most such loans finance value-add projects that deleverage through the execution of a repositioning strategy. Exactly how much of a benefit is interest-only to your investment returns? Assuming a 4.50% interest rate and 70% loan-to-cost, interest-only will boost your annual return on equity by approximately 5.1% compared to the same loan with a 25 year amortization schedule. The lower the interest rate and higher the leverage, the greater the interest-only benefit will be to your ROE, and vice-versa. In the end, the effect on your IRR is less significant (1% +/- IRR gain over a 5 year hold) as you are merely using the time value of money to trade greater upfront “cash-on-cash” returns for a larger loan payoff at maturity.

Closing Costs

Floating-rate loans are typically more expensive to close than fixed-rate loans. Floating-rate lenders carry origination fees that average approximately 1%. Fixed-rate loans are almost always “par” deals, with no origination fee. Floating-rate loans usually require the purchase of an interest rate cap at closing, and although relatively inexpensive, this is a cost that is avoided with a fixed-rate loan.

Prepayment Penalties

The typical floating-rate loan is freely prepayable after 18 months, subject only to a small exit fee which is waived if you convert to a fixed-rate loan with the same lender. Fixed-rate loans tend to have prepayment penalties in the form of yield maintenance, defeasance or declining points. Those choosing a fixed-rate option should be prepared to hold their investment for a period that approximates the term of their loan or have the ability to have a buyer assume their loan in the case of a sale to avoid a prepayment penalty. It should be noted that in a rising interest rate environment, a longer loan term coupled with assumability can actually add or at least retain value that would otherwise be diminished by rising cap rates.

Closing Timeline

This one is a toss-up. A good lender can close any loan in just under 30 days if necessary. Forty-five days is more typical if there is no need for a quicker close. That said, I find that the quicker the close, the cheaper the legal bill and the less opportunity for market disruption and deal fatigue.

Conclusion

Generally speaking, value-add projects are best financed with floating-rate loans and stabilized properties are best financed with fixed-rate loans. As discussed herein, there are plenty of exceptions to this rule. Given how low interest rates are currently, and the likelihood that it will not last forever, for those with a long-term investment horizon that are not opposed to trapping equity via value creation (a great problem to have), it sometimes makes sense to squeeze a value-add bridge loan into a long-term, permanent fixed-rate loan. This has the added benefit of reduced closing costs and greater interest rate clarity. Alternatively, if you are purchasing or refinancing a stabilized property but want to remain nimble and free from prepayment penalties dictating your exit, it may make sense to go the floating-rate route. If you like the floating-rate flexibility, but have a hawkish view on rates, interest rate risk can be managed by purchasing an artificially low interest rate cap at closing. Although the closing costs can be slightly higher, a floating-rate loan may also offer higher leverage and no required amortization, therefore offering greater leveraged return potential.

With the exception of non-cash flowing, deep repositionings which would not qualify for a permanent fixed-rate loan, a good broker can provide you with both fixed and floating-rate options and help you make an informed decision while taking into account your risk profile and investment goals. As they say, “you’re only as good as your options!”