One of the most common underwriting questions in commercial real estate is whether to choose fixed-rate or floating-rate debt.
Many analyses approach the question from a cost perspective. If the loan term is short, floating-rate debt may appear cheaper than locking in a fixed rate. In fact, a recent analysis from Pensford suggests that “the longer the term, the greater the likelihood of that floating interest rates will save money relative to the fixed rate alternative and that borrowers that remain floating generally save money vs the fixed rate alternative”.
You can read their analysis here (I enjoyed reading it):
https://www.pensford.com/resources/fixed-vs-float-analysis
However, while these models can be useful, they raise an important question.
What would have happened if you chose floating vs. fixed rate debt in 2022 or 2023?
Many investors did.
And the consequences are still unfolding today.
When Floating Rates Go Wrong
Between early 2022 and mid-2023, the Federal Reserve increased interest rates at the fastest pace in decades.
Short-term rates moved from near zero to more than 5% in roughly eighteen months. As a result, borrowers with floating-rate loans saw their interest costs increase dramatically.
Deals that initially appeared safe quickly became strained.
Debt service increased. Debt service coverage ratios declined. Cash flow distributions disappeared in many cases.
Across the multifamily and commercial real estate markets, a significant portion of the distress investors are seeing today can be traced back to unhedged floating-rate debt.
This does not mean floating-rate debt is inherently bad. However, it does highlight a key principle of investing.
Investors should manage risk, not speculate on interest rates.
My Personal View on Fixed vs Floating Rates
From a risk management perspective, my general preference is straightforward.
Term debt interest rate risk should be hedged whenever possible.
Interest rates are difficult to predict. Even economists and central banks regularly revise their forecasts. Because of this uncertainty, underwriting should focus on protecting the downside rather than assuming the most favorable outcome.
That often means either:
- Using fixed-rate debt, or
- Properly hedging floating-rate exposure
In other words, the goal is not necessarily to obtain the lowest possible rate. The goal is to create a capital structure that can withstand volatility.
If You Use Floating Rate Debt, Underwrite Conservatively
Floating-rate loans can make sense in certain situations, particularly for:
- Bridge loans
- Value-add repositioning
- Short-term business plans
However, floating-rate debt requires disciplined underwriting.
Below are several practices that can help manage the risk.
1. Study the Forward Curve
Tools such as Chatham Financial or Pensford provide forward interest rate projections based on current market expectations.
These projections are not perfect forecasts. However, they provide a useful reference point for understanding where rates could move.
When underwriting floating-rate loans, the more conservative approach would be to use the upper end of the projected range rather than the most optimistic estimate.
2. Underwrite to the Rate Cap Strike
Not all debt providers offer a traditional fixed rate option or a swap. In that case, floating rate debt is the only option. The interest rate risk in these scenarios can be mitigated via interest rate caps. (You can read more on interest rate risk hedge strategies here.)
However, it is not uncommon to see underwriting models assume interest rates below the cap strike. This creates a false sense of security.
A more conservative approach is to underwrite the deal at the higher of the current interest rate or the rate cap strike rate.
If the deal works under those conditions, the interest rate risk is significantly reduced.
3. Run Sensitivity Analysis
Every underwriting model should include sensitivity testing.
At a minimum, investors should understand:
- At what interest rate the Debt Service Coverage Ratio (DSCR) falls to 1.25x or below
- When DSCR falls to or below 1.0x
- When cash flow turns negative
This exercise quickly reveals how sensitive the deal is to interest rate changes.
A Simple Example
Consider a property producing $1,000,000 of Net Operating Income (NOI) with a $15 million loan.
Scenario 1: 3% Interest Rate
Annual Debt Service: $450,000
Debt Service Coverage Ratio:
DSCR = NOI ÷ Debt Service
DSCR = $1,000,000 ÷ $450,000 = 2.22x
At this level, the deal appears very safe. There is ample coverage and significant room for investor distributions.
Scenario 2: 6% Interest Rate
Annual Debt Service: $900,000
New DSCR:
DSCR = $1,000,000 ÷ $900,000 = 1.11x
The margin of safety is now extremely thin.
Cash flow available for investors may disappear entirely. If occupancy declines or expenses increase, the property could fall below 1.0x DSCR, meaning the income no longer covers the debt service.
This simple example illustrates how interest rate risk can quickly change the financial profile of a deal.
The Bigger Lesson for Real Estate Investors
Interest rates are one of the most powerful variables in real estate underwriting.
Even small changes can significantly impact:
- Debt service coverage
- Cash flow and distributions
- Refinance risk
- Exit valuation
For this reason, experienced investors tend to focus less on minimizing interest cost and more on controlling interest rate risk.
Locking in fixed-rate debt or properly hedging floating-rate exposure may slightly increase borrowing costs in the short term.
However, it can significantly reduce the risk of severe financial stress if rates move in the wrong direction.
Final Thought
The question is not whether floating-rate debt can sometimes be cheaper.
It can.
The more important question is this:
Will the deal still work if interest rates rise?
If the answer is uncertain, the underwriting assumptions may need to be more conservative.
Because successful real estate investing is rarely about predicting the future.
It is about building investments that can survive uncertainty.
Vessi Kapoulian
Breaking down multifamily underwriting one step at a time to create educated and empowered investors
P.P.S. And if you want to go deeper into analyzing multifamily investments step-by-step, my book and Mastering Multifamily Underwriting program walk through this process in plain English – from acquisition to exit.