Fixed, adjustable and everything in between

Borrowers shop rate. Lenders sell structure. The gap between those two things explains a great deal of what goes wrong.

The main structures

Fixed rate, fully amortizing. The rate and payment are set for the full term, typically fifteen or thirty years on residential. At the end, the balance is zero.

Predictable, and in the United States the thirty-year fixed is available on residential property in a way it is not in most countries.

Adjustable rate. A fixed period — commonly five, seven or ten years — then periodic adjustment against an index plus a margin.

The initial rate is usually lower. The risk transfers to you at the reset. Caps limit how far the rate can move per adjustment and over the life of the loan, and those caps are frequently wide enough to be uncomfortable.

Fixed for a term, balloon at maturity. Standard in commercial lending. The rate is fixed for five, seven or ten years, the payment is calculated on a twenty-five or thirty-year amortization, and the entire remaining balance is due at maturity.

You must refinance or sell. That is not a risk you manage, it is a certainty you schedule.

Interest only. No principal repaid during the interest-only period. Lower payments, higher coverage, no equity build.

When the interest-only period ends, the payment jumps sharply because the same principal now amortizes over a shorter remaining term.

What the headline rate does not tell you

Two loans at the same rate can differ substantially.

Points and fees. A lower rate bought with points is a prepayment of interest. Whether it is worthwhile depends on how long you hold, which most people estimate badly.

Prepayment penalties. Common on commercial and investor loans. Structures include step-downs, yield maintenance and defeasance. Yield maintenance and defeasance can be extraordinarily expensive — potentially six figures on a mid-sized loan if rates have fallen.

If your strategy involves selling or refinancing within the term, the prepayment provision may matter more than the rate.

Recourse. Whether the lender can pursue you personally beyond the collateral. Non-recourse loans typically carry higher rates and carve-outs for fraud, waste and certain other acts.

Reserve and escrow requirements. Some loans require substantial reserves held by the lender, which is capital you cannot use.

Assumability. A loan that can be assumed by a buyer becomes a significant asset when rates have risen since origination.

Choosing structure against holding period

The honest way to select is to start from how long you will hold, and then be skeptical of your own answer.

If you genuinely intend to hold indefinitely, fixed-rate long-term debt is worth paying for. The premium buys certainty over a period in which rates will do something you cannot forecast.

If you are executing a defined short-term plan — renovate, stabilize, refinance or sell within two years — shorter-term or floating debt may be appropriate, provided the plan has slack in it.

The failure mode is a short-term structure attached to a long-term hold, chosen because the initial payment was lower. That is a bet that conditions at reset will be favorable, made by someone who has not priced the bet.

The 2021 lesson, stated plainly

A large volume of commercial real estate was financed at historically low rates on five-year terms, with the reasonable expectation of refinancing on similar terms.

When those loans matured into a much higher rate environment, the new loans were smaller — because DSCR sizing is a function of the payment — and the shortfall had to be funded with equity that in many cases did not exist.

Properties that were operationally healthy went into distress for reasons entirely unrelated to their tenants.

The takeaway is not that floating or short-term debt is wrong. It is that the refinance is part of the deal, and it needs underwriting at rates well above today's.

The stress test worth running

Before signing, model the loan at maturity assuming the prevailing rate is three points higher than today.

Does the property still support the balance at your lender's coverage requirement? If not, how much cash would you need to bring?

If the answer is more cash than you can produce, you are relying on conditions rather than on the asset.

The general principle

Match the duration of the debt to the duration of the plan, and then extend it a bit further than feels necessary.

Certainty is worth paying for, and the market has repeatedly demonstrated that it is worth more than it appears at origination.

General information about real estate finance, not investment, tax or legal advice. Loan products and terms vary by lender and jurisdiction. Consult qualified professionals about your own circumstances.