A floating rate quoted below the fixed one looks like free money. Whether it is depends on a single number, and that number rarely gets run.
That number is not today’s rate. It is the rate at which your building stops covering its debt at the level your lender requires.
What you are actually buying
A fixed rate locks your payment for the whole term. A floating rate moves with an index, usually SOFR plus a spread, and it resets as often as monthly.
The floating rate almost always starts lower. That is the entire appeal, and the discount is real.
With fixed money you are buying certainty. With floating money you are selling certainty back to the lender in exchange for a discount today. Both are legitimate trades. Neither one is right for every owner.
The same building under three rates
Take the 12-unit example from How to Refinance a Small Apartment Building: $275,200 of lender NOI carrying a $2.72 million loan.
Fixed at 6.5 percent. The annual payment runs about $220,000. Coverage is $275,200 divided by $220,000, or 1.25. That sits exactly on the floor most lenders require, with nothing to spare.
Floating at 5.75 percent. The payment drops to about $205,000. Coverage rises to 1.34. The gap between the two payments is roughly $15,000 a year that stays in the building.
Floating at 7.75 percent, after a 200 basis point move. The payment climbs to about $246,000. Coverage falls to 1.12.
At 1.12 you are below what almost every lender requires. You are not in default and you can still write the check. But you are in a weak position at your next refinance, and depending on your loan documents you may have tripped a covenant.
Same building, same income, three very different positions. The owner chose none of the three rates.
Find your break point
Five steps. Give it an afternoon.
- Start with lender NOI, not your own bottom line. Use the figure an underwriter would reach after a vacancy factor, normalized expenses, a management fee, and replacement reserves.
- Read the coverage floor out of your loan documents. On most small apartment loans it is 1.25.
- Divide. On the example, $275,200 divided by 1.25 gives $220,160. That is the largest annual payment the building supports.
- Find the rate that produces that payment on your loan balance and your amortization schedule. On $2.72 million over 25 years, it lands right around 6.5 percent. That is your break point.
- Subtract the floating start rate from the break point. 6.5 minus 5.75 leaves 0.75, or 75 basis points of room.
Step 1 decides the other four. If you cannot defend your income line, your break point is a guess dressed up as arithmetic. Fifteen minutes with the NOI Leak Check will tell you whether the number you are working from is the number a lender will use.
Seventy-five basis points, priced
Now put the two halves of the trade next to each other.
The floating rate pays you about $15,000 a year. The room it leaves you is 75 basis points. So the owner on this building is being paid $15,000 a year to accept that a three quarter point move puts the loan below its coverage floor.
Write it that way and the decision stops being about rate quotes. Some owners will take that trade without blinking. Others will read it once and call the lender back for the fixed quote. Both answers are defensible. Only one of them is yours.
Three things widen the room, and all of them sit on your side of the table: more defensible income, a longer amortization, and a smaller loan. Every $1,000 of NOI you can document lifts the payment your building supports by $1,250 at a 1.25 floor, which moves the break point up and buys you room you did not have to pay a lender for.
How to decide
Ask three questions in this order.
- What is my break point? Not the market’s, not the one on the term sheet. Mine, on this building, at the coverage floor in my documents.
- How much room does the floating quote leave? State it in basis points. Then ask whether an ordinary move in that index would consume it.
- What happens to me if it does? If the answer is a tighter refinance you can manage, floating may fit. If the answer is a covenant breach or a capital call, you have just priced certainty and found it cheap.
Do not choose between fixed and floating by comparing today’s rates. Today’s rates only tell you which one is cheaper today, and that was never in dispute. Run the break point, state the room in basis points, then answer the lender.
Own a building in Washington DC, Virginia, or Maryland? Here is what a local lender expects when you bring them either structure: Refinancing a DC Apartment Building
Get a read on your building. Request a building audit and I will run your break point on your own numbers before you answer the lender.
Frequently asked questions
What is the difference between a fixed and a floating rate on an apartment loan? A fixed rate locks your payment for the whole term. A floating rate moves with an index, usually SOFR plus a spread, and resets as often as monthly. Floating almost always starts lower, so you are trading certainty for a discount today.
How do I find my break point? Divide lender NOI by the coverage floor in your loan documents to get the largest annual payment your building supports. On $275,200 at 1.25 coverage, that is $220,160. Then find the rate that produces that payment on your balance and amortization.
When does a floating rate make sense? When the distance between your starting rate and your break point is wide enough that an ordinary rate move will not push coverage below the floor. At 5.75 percent against a 6.5 percent break point, the room is 75 basis points. That is thin.