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.
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
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
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
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
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.
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
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