Fixed-Rate Debt in a Volatile Rate Environment

Fixed rate debt is the cornerstone of conservative real estate investing. It removes interest rate risk and locks in the cost of capital.

In a volatile rate environment, fixed rate debt is more valuable, not less. Here is how to think about it.

What Fixed Rate Means

The interest rate on the loan is locked for the term. A 10 year fixed rate loan stays at the same rate for 10 years regardless of where market rates move.

If market rates rise, you are protected. If market rates fall, you can refinance to capture the lower rate. The optionality favors the borrower.

The 2023 Lesson

From 2020 to 2022, floating rate debt was popular because rates were so low. SOFR plus a spread of 250 to 350 basis points gave coupons under 5 percent.

Then SOFR went from 0 to 5.3 percent in 18 months. Floating rate loans saw their coupons double or triple. Properties that had been performing well saw their cash flow collapse.

The same properties on fixed rate debt would have been unaffected. The lesson is structural.

Cost of the Lock

Fixed rate debt usually costs more than floating rate at acquisition. The spread can be 50 to 150 basis points depending on market conditions.

In a normal rate environment, that spread is the insurance premium for rate risk protection. It is worth paying for properties you intend to hold.

In the current environment, fixed rate spreads have narrowed because lenders see less compensation in floating. The cost of the lock is lower than usual.

Prepayment Penalties

Fixed rate debt usually has prepayment penalties. Yield maintenance or step down.

This is the tradeoff for the rate certainty. The lender wants their yield over the loan term. If you exit early, you pay them for the loss of that yield.

Step down penalties are more borrower friendly. Yield maintenance can be brutal in falling rate environments. Read the loan documents.

Matching the Hold Period

Fixed rate term should match your intended hold. If you plan to hold 7 to 10 years, take a 7 to 10 year fixed loan. Do not take a 5 year loan and hope rates cooperate at refinance.

The match removes refinance risk. You know exactly what your cost of capital is for the entire intended hold.

The Refinance Strategy

Even with fixed rate debt, refinance is part of the strategy. You can refinance at any time, paying any applicable prepayment penalty.

If rates drop materially during the hold, you might refinance to capture lower rates and pull out additional capital. Run the math including the prepayment penalty.

Investor Communication

LPs should know the debt terms. Rate. Term. Amortization. Prepayment structure. Loan covenants. These shape the deal as much as the property itself.

Sponsors who hide the debt structure are hiding for a reason. Sponsors who walk you through it are running a disciplined operation.