By Todd McNeill
Everyone would love to have the perfect fixed-rate loan when considering their next real estate acquisition, development, or property refinance. With interest rates at historical lows, a fixed-rate loan is very tempting. However, fixed rate loans may not always offer the best financing solution.
Here is our “Top 5” list to help you consider the benefits of a fixed versus floating-rate loan.
1) Flexibility – If the Borrower’s goal is to maintain maximum flexibility, then a floating-rate mortgage may be the best route. When a lender fixes a rate, it usually involves the lender entering into a hedge or swap contract that carries penalties if that hedge or swap is retired prior to loan maturity. Thus, if you must prepay a fixed-rate mortgage, there is likely going to be a prepayment penalty. The penalty amount is determined by a calculation called Defeasance or Yield Maintenance. Under varying circumstances the penalty for prepaying a fixed-rate loan can often be cost prohibitive.
Floating-rate mortgages, on the other hand, rarely carry prepayment penalty. If you plan on holding the property for a short-term horizon (1 to 4 years), a floating-rate mortgage may be the best option to minimize any frictional prepayment costs.
2) Perceived Property Valuation – If a Borrower has acquired a property at a significant discount to market value or if the Borrower plans to add significant value, then a floating rate should be considered. Most CRE Borrowers are usually forecasting a sale or a refinance of the property within the first five years of ownership. By selecting a fixed-rate mortgage at acquisition, one might very well be underleveraging a property with respect to its future potential and then (as noted above) be faced with prepayment penalties when the property is ready to be sold or refinanced. This situation is often referred to as “Trapped Equity.”
Floating-rate options allow one to avoid this pitfall. So, if significant increases in operating income are forecasted for a property, choosing a floating-rate mortgage will allow the debt financing to be “reset / resized” once the property achieves a higher, stabilized value.
3) Investment Motivation – If a Borrower’s investment goal is to acquire a property for its stable, long-term cash flow potential, a fixed-rate loan will most likely be the best alternative. For example, 1031 Investors prefer a fixed-rate mortgage since these buyers are seeking cash flow. Utilizing a fixed-rate mortgage transfers the risk of rising interest rates from the Borrower to the Lender. A Borrower can forecast consistent, stable cash flows on their investment by using a fixed-rate mortgage. Fixed-rate lenders generally are more expensive than the floating-rate alternatives. If long-term stable cash flows are not a goal of the Borrower, a floating-rate mortgage can provide greater cash flow as the rates are usually lower. However, if rates move higher during the loan term, the cash flow may decrease as the Borrower takes all of the rate risk in a floating-rate mortgage.
4) Borrower Risk Profile – Borrowers with a higher tolerance for risk usually will lean towards a floating-rate loan. Many of these Borrowers are seasoned CRE participants who have the instinct (or empirical data) for when interest rates are headed up or down. Since these Borrowers usually have a good handle on the direction of interest rates, they understand when it is the right time to fix their interest rate or float a rate as the case may be. For example, since the beginning of 2013, many of our firm’s clients have decided to convert their floating-rate loan portfolio to fixed-rate portfolio. Nonetheless, if a property is destined for sale or disposition in the near term, the frictional costs of refinancing along with a higher coupon rate for a fixed-rate has to be factored into any refinance decision.
5) Loan Structure – Many Lenders attempt to make their fixed-rate mortgage products somewhat user-friendly for the Borrowers that are undecided on the future of their assets. While most fixed-rate mortgages have prepayment penalties, some fixed-rate mortgages contain “assumption” clauses. This will allow a new buyer to assume the existing debt subject to being approved by the existing lender. The assumption of an existing mortgage should be carefully analyzed. First, the existing mortgage may be under-leveraged based on the purchase price of the property. Second, a Seller is limiting his buyer pool to only those buyers that are willing to “assume” the current loan terms. This may very well exclude all cash buyers or buyers that prefer alternative, market-rate financing.
Some fixed-rate lenders also will allow secondary financing to be put in place so that a potential buyer can effectively increase the leverage of the property without prepaying the existing mortgage, an option for buyers that are looking at a property with existing fixed-rate debt that is under-leveraged.
With over $9 billion of closed transactions during the past 20 years, Metropolitan Capital Advisors has significant experience in dealing with a wide variety of fixed and floating-rate loan products. MCA welcomes the opportunity to review your business plan and objectives to help you analyze all your options and then make a specific recommendation. Please contact an MCA Senior Director to further discuss your financing requirements at 972-267-0600 or www.metcapital.com .