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Floating or Fixed Rates: Considerations in Choosing a Commercial Real Estate Mortgage
When financing a commercial real estate purchase, the devil finds its way into the details in surprising ways. One of the details that can provide a fair amount of headache for developers and investors is the decision to choose either a fixed or a floating mortgage rate. There are, obviously, risks and rewards to each, and there may be times when the safest bet isn't always the best one.
Fixed-rate mortgages are the most risk-averse bet, so the analysis will begin there. The obvious benefit to a fixed-rate mortgage is the lack of volatility. If the borrower is comfortable with the rate, he or she can just lock in for the holding period and enjoy stress-free stable cash flows, shifting the risk of rising interest rates to the lender. Many fixed-rate mortgages are non-recourse as well, keeping personal liability for the borrower at bay. The disadvantages to fixed-rate mortgages begin with the rate - fixed-rate mortgages start at higher rates than introductory floating-rate mortgages. Also, fixed-rate mortgages often carry a yield maintenance provision that will impose substantial penalties on the borrower if the mortgage is paid before it reaches maturity, i.e., a pre-payment penalty. Some mortgages, however, contain an assumption clause that will allow a new buyer to assume the debt (as long as the lender approves), thus mitigating the factor of a prepayment penalty.
Floating-rate mortgages were vilified in the past as a sign of irresponsible borrowing, but they are, like any investment vehicle, a calculated risk. First of all, the lower introductory interest rate discussed above is a result of the age-old financial wisdom that added risk should be accompanied by added reward. In addition to a lower initial interest rate, another benefit of a floating-rate mortgage is flexibility - investors planning to only hold the property for a short term can do so safely without fear of a prepayment penalty. Not every commercial borrower looks to be a long-term holder - properties that are ripe for quick sale or refinance within the first few years of ownership benefit from the lack of prepayment penalties on floating-rate loans. The obvious downside to a floating-rate mortgage is the assumption of the risk that interest rates could rise. Seasoned borrowers with a high tolerance for risk and a sense of where rates might be headed can capitalize on low rates using floating-rate mortgages. These borrowers should carefully consider whether they can absorb the potential losses due to rising rates.
The bottom line is that floating-rate mortgages aren't entirely anathema anymore, and fixed-rate mortgages have drawbacks despite their stability. Commercial real estate borrowers should consider stability, flexibility, and above all, risk in considering whether a fixed or a floating interest rate is right for their commercial real estate mortgage. For information on commercial real estate financing, consult the attorneys at McBrayer.
James H. Frazier, III is the Managing Member of the firm, a position he has held for over 18 years. Mr. Frazier's practice focuses on real estate, bankruptcy, mergers and acquisitions and general corporate practice with special emphasis on mineral and energy law. He can be reached at firstname.lastname@example.org or (859) 231-8780, ext. 303.
This article is intended as a summary of state and federal law and does not constitute legal advice.