Interest Rate Risk: What Happens When Your Floating Rate Loan Resets
FAM Capital | Investor Education Series
A property that cash flows beautifully at one interest rate can bleed money at another. The building does not change. The tenants do not leave. The rents do not drop. The only thing that changes is the rate on the loan, and that single variable can turn a profitable investment into a distressed one in the span of a single rate adjustment. This is not a hypothetical scenario. It happened to billions of dollars in real estate over the past few years, and the investors who got hurt were not reckless speculators. Many of them were experienced operators and informed limited partners who understood the properties they owned but underestimated the risk embedded in the debt they used to buy them.
Interest rate risk is the most mechanical risk in real estate. It has nothing to do with the quality of the building, the strength of the market, or the competence of the operator. It is pure math. When the rate on your loan goes up, your debt service payment goes up. When your debt service payment goes up, your cash flow goes down. If the rate goes up enough, your cash flow goes to zero or below, and you are writing checks to keep the property afloat instead of collecting distributions. This article explains exactly how that happens, what the moving parts are, and how both passive investors and direct property owners can evaluate and protect against this risk.
How Floating Rate Loans Work
A floating rate loan, sometimes called a variable rate or adjustable rate loan, has an interest rate that changes periodically based on a benchmark index. In commercial real estate, the most common benchmark is SOFR, which stands for the Secured Overnight Financing Rate. SOFR is set by the Federal Reserve Bank of New York and reflects the cost of overnight borrowing collateralized by U.S. Treasury securities. It moves in response to Federal Reserve policy and broader credit market conditions.
Your floating rate is composed of two parts: the benchmark rate (SOFR) plus a spread. The spread is a fixed margin that the lender adds on top of SOFR to compensate for the risk of lending to you. A typical spread on a multifamily bridge loan might be 200 to 350 basis points (2.00% to 3.50%) above SOFR. If SOFR is at 4.50% and your spread is 2.50%, your all-in rate is 7.00%. If SOFR drops to 3.00%, your rate drops to 5.50%. If SOFR rises to 5.50%, your rate rises to 8.00%. The spread does not change. The benchmark does, and your payment moves with it.
The rate typically resets on a monthly or quarterly basis, depending on the loan terms. Each reset recalculates your interest payment based on the current level of the benchmark. On a $10 million loan, a 100 basis point increase in SOFR adds $100,000 per year in interest expense. That is $100,000 that was previously flowing to investors as distributions or sitting in reserves as a safety cushion. It did not go to a better use. It went to the lender because the rate moved.
Most floating rate loans in commercial real estate are bridge loans. Bridge loans are short-term financing, typically two to three years with one or two extension options, designed to provide capital during a transitional period: an acquisition, a renovation, a lease-up. The expectation is that the borrower will complete the business plan, stabilize the property, and then refinance into permanent fixed-rate debt or sell the asset before the bridge loan matures. The entire structure is built on the assumption that the transition happens on time and that the rate environment cooperates while it does.
What Happens When the Rate Moves Against You
Let us put specific numbers on this. A sponsor acquires a 150-unit apartment building for $15 million using a $12 million floating rate bridge loan. At origination, SOFR is at 2.00% and the spread is 2.75%, giving an all-in rate of 4.75%. The annual interest payment is $570,000. The property generates $1.1 million in NOI. After debt service, there is $530,000 left for distributions, reserves, and operating expenses. The deal looks strong.
Eighteen months later, SOFR has risen to 5.25%. The all-in rate is now 8.00%. The annual interest payment has jumped to $960,000. The NOI has grown modestly to $1.15 million because the renovations are underway and some units have been turned at higher rents. But the debt service has consumed nearly all of the gain and then some. After debt service, there is $190,000 left. Distributions are cut or suspended. The reserves that were supposed to fund the remaining renovations are being redirected to cover debt service.
Now the business plan is in trouble. The renovations slow down because the capital is going to the lender. Fewer units get turned, which means less rent growth, which means the stabilization timeline extends. The bridge loan was supposed to be refinanced into permanent debt after the property stabilized, but the property has not stabilized because the capital that was supposed to fund the renovations is covering the higher debt service. The loan maturity is approaching, and the refinance options are limited because lenders underwrite based on the property’s current income, not the projected income from the original business plan.
Rate Caps: What They Are and What They Actually Protect
A rate cap is an insurance policy on a floating rate loan. It sets a ceiling on the benchmark rate for a defined period. If you purchase a rate cap that caps SOFR at 3.00% for two years, and SOFR rises to 5.25%, the rate cap provider pays you the difference on the notional amount of the loan. Your effective rate stays at your spread plus 3.00%, regardless of where SOFR actually goes, for the duration of the cap.
Rate caps are typically required by lenders on floating rate bridge loans. They protect the lender as much as the borrower, because a borrower who cannot make payments creates a problem for the lender too. The cap ensures that debt service does not exceed a certain level, which preserves the borrower’s ability to make payments and maintain the property.
Here is where the cost becomes a factor. Rate caps are not free, and their cost fluctuates dramatically based on where rates are and where the market expects them to go. On a $12 million loan, a two-year rate cap with a 3.00% SOFR strike might have cost $50,000 when rates were low and expected to stay low. When rates were rising rapidly and volatility was high, that same cap might cost $300,000 to $500,000 or more. That cost is paid upfront at closing and is not recoverable. It is an insurance premium. If rates stay below the cap, the policy expires worthless. If rates spike above the cap, the policy pays out.
The critical risk event is what happens when the rate cap expires. Most bridge loans have a two-year initial term with extension options. The rate cap purchased at origination covers the initial term. When the borrower exercises the extension option, a new rate cap must be purchased for the extension period, and the cost of that new cap is based on current market conditions. A sponsor who purchased a rate cap for $75,000 at origination may face a $400,000 bill to purchase a replacement cap for the extension period. That $400,000 comes from reserves, additional investor capital, or operating cash flow. If the sponsor does not have the capital to purchase the replacement cap, they cannot extend the loan.
For the 150-unit example above, assume the original rate cap cost $80,000 and capped SOFR at 3.00%. The cap expired after two years. The property has not yet stabilized. The sponsor needs to extend the bridge loan for one year. A new one-year rate cap with a 3.00% strike costs $350,000 at the current rate environment. The sponsor must fund that $350,000 or lose the extension option. If they fund it from reserves, those reserves are no longer available for renovations. If they issue a capital call, investors are writing additional checks on a deal that has not yet delivered the returns it promised. The rate cap protected the deal during the initial term, but the cost of the replacement cap became a financial burden that compounded the distress rather than alleviating it.
What Went Wrong Across the Industry
In recent years, the commercial real estate industry experienced exactly this pattern at scale. Hundreds of billions of dollars in floating rate bridge loans were originated during a period of historically low interest rates. The business plans attached to those loans assumed that rates would stay low or decline, that properties would stabilize quickly, and that refinancing into permanent debt would be straightforward. When rates rose sharply and stayed elevated longer than anyone projected, the math broke on a massive number of deals simultaneously.
Properties that were performing well operationally found themselves in financial distress purely because of the debt structure. Sponsors who had executed their renovation plans on time and on budget still could not refinance because the higher rate environment changed what lenders would offer. Investors who had been receiving distributions saw those distributions cut or eliminated. Capital calls went out. Extensions were exercised at enormous cost. Some properties were sold at prices below the original purchase price, wiping out investor equity entirely.
The buildings were not the problem. The markets were not the problem. The operators, in many cases, were not the problem. The debt was the problem. The decision to use floating rate financing with a short-term maturity in an environment where rates could move significantly introduced a risk that overwhelmed every other aspect of the investment. And that risk was knowable, measurable, and avoidable at the time the debt was placed.
Why Fixed Rate Debt Wins for Most Situations
A fixed rate loan does exactly what it sounds like. The interest rate is locked for the entire term of the loan. If you close a $10 million loan at 5.75% fixed for seven years, your annual debt service is $575,000 every year for seven years regardless of what happens to SOFR, the Fed Funds rate, or the broader economy. Your payment does not change. Your cash flow projection on day one is the same as your cash flow projection in year five. There is no rate reset. There is no cap to purchase. There is no refinance risk driven by rate movements.
The cost of this certainty is typically a slightly higher rate at origination compared to a floating rate loan. When SOFR is at 4.50% and a floating rate bridge loan is priced at SOFR plus 2.50% for an all-in rate of 7.00%, a fixed-rate agency loan might be priced at 5.50% to 6.00%. The fixed rate is lower on day one, and it stays the same for the entire term. The floating rate is higher on day one and could go higher or lower depending on the market. Over the life of the loan, the fixed rate borrower pays a known amount. The floating rate borrower pays an unknown amount.
For a stabilized or near-stabilized property with a long-term hold strategy, fixed rate debt is almost always the right choice. It eliminates the single largest variable cost in the deal. It allows the operator to project cash flow with confidence. It protects investor distributions from rate volatility. And it removes the refinance pressure that comes with a short-term maturity on a floating rate loan.
Floating rate debt has a legitimate role in short-term transitional situations where the borrower has a clear, executable plan to stabilize the property and transition to permanent financing within the loan term. A 12-month bridge loan on a property that needs minor renovations and will qualify for agency financing within a year is a reasonable use of floating rate debt. A three-year bridge loan on a heavy value-add project in an uncertain rate environment is a gamble, even if the business plan is sound. The question is not whether floating rate debt can work. It is whether the risk it introduces is justified by the benefit it provides. In most cases, for most investors, it is not.
What This Means for Passive Investors and Direct Owners
For passive investors reviewing a syndication opportunity, the debt structure is one of the most important things to understand before you invest. It is not enough to know the projected returns and the business plan. You need to know what type of loan is on the property, whether the rate is fixed or floating, what the current rate is, when the loan matures, whether there are extension options, what conditions must be met to exercise those extensions, and whether a rate cap is in place. If the deal uses floating rate debt, you need to understand the downside scenario: what happens to your cash flow and your investment if rates stay elevated or rise further during the hold period. If the sponsor cannot answer those questions clearly, or if the answers reveal a debt structure that depends on favorable rate movements to succeed, that is a risk you should weigh heavily.
For direct property owners, the choice of debt is yours, and it is one of the most consequential decisions you will make. The temptation with floating rate debt is the lower initial rate and the flexibility of shorter terms. But that lower rate comes with uncertainty, and uncertainty in your largest expense line item cascades through every other financial projection you make. If you own a stabilized rental property and plan to hold it for five or more years, a fixed rate loan removes the single largest source of financial risk in your investment. The slightly higher rate is the price of sleeping well at night, and it is a price worth paying.
The lesson from recent years is not that floating rate debt is inherently bad. It is that floating rate debt introduces a risk that is easy to underestimate when rates are low and easy to regret when rates are high. The operators and investors who came through the recent cycle unscathed were overwhelmingly the ones who used fixed rate debt, matched their loan term to their hold period, and did not bet their investment on a rate environment they could not control.
The Bottom Line
Interest rate risk is not about the economy, the Fed, or the bond market. It is about your loan. A floating rate loan makes your largest expense variable. A fixed rate loan makes it constant. When the variable moves against you, every dollar of increased debt service comes directly out of your cash flow, your reserves, and eventually your returns. The building does not care what SOFR is. The tenants do not care what SOFR is. Your lender cares, and your bank account reflects it.
You cannot control interest rates. You cannot predict where they will be in two years. What you can control is the type of debt on your property or the type of debt your sponsor uses in the deals you invest in. Fixed rate debt is not exciting. It does not offer the possibility of lower payments if rates decline. What it offers is certainty, and in real estate investing, certainty in your cost structure is one of the most valuable things you can buy. The investors who learned this lesson from experience paid for it with lost distributions, capital calls, and diminished returns. The investors who learn it from understanding the mechanics can avoid paying that tuition entirely.
