Market analysis

The Rate Debate

Interest rate analyses provide unique perspectives on financing investments.

Every month in Wichita, Kan., a small group of accomplished real estate developers and investors known as the "Dirty Dozen" meets over breakfast to share what they've observed in markets across the country and to discuss their differing investment philosophies. A regular debate at these gatherings is whether it is better to float or fix mortgage rates on commercial real estate investments. Most of the Dirty Dozen strongly believe it is best to fix rates on long-term investments; one group member, however, has done extremely well by floating interest rates on his real estate investments.

The Trade-Offs

Even novice commercial real estate investors understand the benefits of fixed-rate financing. Fixed-rate mortgages protect borrowers against rising interest rates and, by locking in a specific rate, eliminate a major source of cash flow uncertainty. They provide other advantages as well. Fixed-rate loans typically are nonrecourse - so borrowers are not personally liable - and many offer terms of five, 10, or even 20 years without a call provision.

Of course, there are trade-offs that temper these benefits. Most notable is a loss in flexibility. Most long-term, fixed-rate mortgages have yield maintenance provisions that impose substantial prepayment penalties. This effectively prohibits refinancing the mortgage if future rates fall, and it also may substantially limit the property's selling options. Furthermore, fixed-rate mortgages generally have higher initial interest rates than variable-rate loans with similar terms. Historically this difference has been between 150 and 200 basis points, although recent spreads have been much smaller.

In contrast, adjustable-rate loans offer investors greater flexibility when future economic conditions change. Not only do they start with lower initial interest rates, they also allow investors to ride the market down when interest rates fall, albeit with the added risk that future rates might rise rather than fall.

Will Rates Rise?

Of course, the uncertainty of future rates is key to the fixed vs. floating decision. Ask a Federal Reserve economist what will happen to interest rates and the answer likely will be, "They'll fluctuate." History reveals this is indeed what occurs.

Table 1 illustrates how short- and long-term U.S. Treasury rates have moved during the past 50 years. Prior to the early 1980s, interest rates followed a slow but steady rise. Since then, rates have charted an equally consistent downward trend. However, at times during both periods, interest rates have moved counter to the prevailing long-term trend. For example, while the trend of declining interest rates since the early 1980s appears obvious in Table 1, in 1990 it was by no means clear that this trend would continue. Similarly, it is unclear now whether we are on a new, long-term upward trend, or if the recent rate rise is a short-run phenomenon. Finally, although both short- and long-term rates do indeed fluctuate, short-term rates clearly are the more volatile of the two.

A Simple Exercise

Can this history of interest rate fluctuation provide an answer to the fixed vs. floating question? A simple exercise may shed some light: Start at a particular month in the past and compare the then-prevailing long-term fixed rate with the actual path of short-term interest rates over a five-year holding period to determine whether an investor would have gained or lost money by floating the interest rate.

To begin, assume that commercial mortgage rates are tied to Treasury securities with the same term. Thus, a five-year, fixed-rate loan is tied to the five-year, constant maturity Treasury rate, while the floating-rate loan adjusts every three months based on the prevailing three-year Treasury rate. For ease of analysis, assume a constant 185-bp spread over the appropriate index for both fixed and adjustable loans.

Because the constant maturity series for three-month Treasury bills only dates back to 1981, use the secondary market rate as the index for short-term loans. All other Treasury rates used in this analysis are based on the appropriate constant maturity series. Historical data for all of these rates can be downloaded from the Federal Reserve Bank of St. Louis at http://research.stlouisfed.org/fred2.

As an example, consider what would have happened with a five-year mortgage beginning in January 1999. That month the average five-year Treasury rate was 4.60 percent. With a 185-bp margin, a five-year, fixed-rate mortgage would have had a 6.45 percent rate. In contrast, the initial interest rate on an adjustable-rate mortgage that month was 6.19 percent (185 bp above the three-month Treasury rate of 4.34 percent). Of course this rate adjusts every three months based on the movement of the three-month Treasury rate, again, with a 185-bp spread.

Table 2 shows the interest rates that would have been paid on fixed- and adjustable-rate loans over the five-year holding period starting in January 1999. During the loan's early months, the three-month Treasury rose; by October the adjustable interest rate was above 6.45 percent, the fixed rate. By the following October, it rose to 7.96 percent, a 177-bp increase in only 22 months. However, beginning in January 2001, short-term rates began to fall dramatically. Indeed, over the last half of the five-year holding period the rate on the adjustable-rate loan was approximately 300 bp lower than the fixed rate. Overall, an investor floating the interest rate over this holding period would have earned very favorable returns.

Of course, January 1999 is only one possible starting point for a holding period. Table 3 shows what happened at several other starting points during the past 50 years. In some cases, floating the rate would have been a clear winner. In others, it would have been much better to lock.

Crunching the Numbers

To answer the fixed vs. floating question, it's important to know how much an investor can expect to save by floating the interest rate over a random five-year holding period. Between April 1953 and January 2000 there are 562 different months that could start a five-year holding period, and the interest rate environments during these possible holding periods have varied dramatically. Given the wide range of interest rate cycles that have occurred during this 50-year period, it is reasonable to suppose that these holding periods approximate possible future interest rate scenarios.

For each of these 562 possible starting points, how would an investor have fared on a $1 million loan with an adjustable rate vs. a fixed rate? To keep the calculations simple, assume these are interest-only loans and that the investor receives a zero return on any savings (or additional costs) from the adjustable-rate loan. Based on actual changes in the three-month Treasury security, calculate the total savings (or added interest costs) an investor would have reaped (or paid) during each of the possible five-year holding periods in the past.

Table 4 provides a summary of this analysis. Using $50,000 increments, this chart shows the distribution of the gains and losses from floating the interest rate over all possible five-year holding periods. For example, an investor floating a rate saved between $0 and $50,000 in 152 of the possible 562 holding periods during the last 50 years; in 10 instances the interest savings totaled more than $300,000 over the holding period. In contrast, in another 10 cases, the investor paid an extra $150,000 to $200,000 in interest by floating the rate.

On average, an investor choosing an adjustable-rate mortgage would have "won" 72 percent of the time, with average interest savings of $53,323. This translates into roughly a 1 percent reduction in the average interest rate due to floating the rate ($53,000/5 years = $10,600 per year or 1.06 percent annually on a $1 million loan). At the extremes, the best possible case saw a $341,600 savings (starting in September 1981), while the worst starting month for floating (July 1977) resulted in $172,725 of extra interest.

Does the Holding Period Matter?

Because five years is a fairly short holding period, this analysis also should be performed with a 10-year holding period. In this case, the fixed-rate loan is tied to the 10-year Treasury security, while the adjustable-rate loan once again floats with the three-month Treasury.

Table 5 illustrates that with a 10-year holding period an investor floating the rate would have "won" 54 percent of the time, with average interest savings of $104,705. Once again the savings is roughly 1 percent of the initial principal balance. Because of the longer holding period, the biggest gain is much larger, $744,525 (if the loan started in June 1984), and the biggest loss is much larger as well ($212,825 beginning in December 1976).

Overall, these results suggest that investors can save money by choosing to float the interest rate: During the past 50 years, the average interest savings from adjustable-rate mortgages has amounted to approximately 1 percent per year.

In retrospect, the results simply confirm a basic economic principle. After all, an investor who floats the interest rate is absorbing the risk that rates will rise in the future, and basic financial theory dictates that investors must be compensated for risks they bear.

Caveat Investor

Although this analysis does shed light on the potential benefits of variable-rate loans, investors should keep in mind the exercise's simple nature. While the example assumes a constant 185-bp spread between the contract rate and the underlying index, in practice, spreads can differ for fixed- and adjustable-rate loans based on market conditions. Any difference in this margin across loan products could affect the relative attractiveness of floating.

Second, the analysis assumes an interest-only loan to keep the savings calculations simple. Because most commercial real estate loans amortize, interest rate differences early in the life of the loan will matter more than those differences that occur later. Given that adjustable-rate loans typically start with a lower initial interest rate, this suggests that the analysis underestimates the true net benefit of floating the rate.

Finally, although the analysis assumes a zero return on any interest savings and a zero cost to added interest that must be paid, in reality, investors who save on their interest payments will use these savings for some other purpose and could earn additional return on these funds.

To Float or Not?

In the end, this analysis supports both choices, depending on the investor and the project's specifics. If the investment generates sufficient cash flow and can absorb the losses that are incurred in a rising rate environment - and if the investor is willing and able to accept the losses when rates rise - there is money to be made on average by floating the rate. On the other hand, many investors may view one percentage point - the average increase in interest costs - as a relatively cheap form of insurance to guarantee a good night's sleep.

Stanley D. Longhofer

Stanlet D. Longhofer is the Stephen L. Clark chair of real estate and finance and the founding director of the Center for Real Estate at Wichita State University in Wichita, Kan. Contact him at (316) 978-7120 or realestate@wichita.edu.

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