The Fed Funds futures market is currently pricing in a high probability of a September interest rate cut – although that is not a certainty.  Many clients with financing needs are looking to their commercial relationship managers for advice on how to structure and price their credit facilities.  We recently worked with a lender who was advising a real estate investor on the pros and cons of a term loan with pricing options that included a floating index, a fixed rate, a swapped rate, or a floater with a cap.  Some borrowers are confused about the anticipated FOMC meeting this month and what that means for their financing costs, while others are equally confused by the administration’s chorus calling for lower short-term interest rates and a possible challenge of the Federal Reserve’s independence.  We believe that a community bank relationship manager who can provide thoughtful guidance when advising commercial borrowers on the options, the costs and benefits of various terms, structure and pricing can increase their value to, and loyalty with, the borrower.  In this article we want to share this particular lender’s advice to his borrower on the various available structures.

Considerations When Advising Commercial Borrowers

First, the lender pointed out that the client was an astute real estate investor, but not a capital markets forecaster.  Therefore, the lender emphasized that deciding on a structure should be primarily based on the borrower’s risk tolerance, investment timeline, and total debt roll portfolio.  For example, for properties that were low leverage (for example 2.0X DSCR) the borrower had higher risk tolerance.  If the client were planning to hold an investment for a lengthy period (for example estate planning property, or marquee investment goal) a longer-term commitment would be beneficial.  If the client held numerous real estate properties financed with short-term debt, then extending duration on some liabilities would be prudent for diversification of the debt roll.

Second, the lender addressed the borrower’s market outlook.  Most reasonable clients agree that no one can outwit the market consistently.  However, the lender pointed out, astutely, that if the market expectations are met (the market forecast is realized), and transaction costs are excluded, and risks are equal, then a loan priced on a floating index, fixed rate, swapped or capped would all cost the same to the borrower.  In other words, the expectations of all four options lead to the same result if the market’s expectations are realized.  However, the risks that come with these four options are very different.

The lender’s explanation of the distinct options available to the client are summarized in the table below.

Feature 

Fixed Rate

 Floating Rate Swapped Rate

Capped Rate
Payment stability High: Your payments are predictable and stable for the life of the loan. Low: Payments can rise, or fall based on a benchmark index (e.g., SOFR or Prime). High: Creates predictable, fixed payments, which are typically 50 to 100 bps lower than comparable fixed-rate loans. Variable with a ceiling: Payments can go down but will not exceed a pre-determined cap rate.
Initial cost Often higher than a floating rate or a swapped rate, as the bank prices in the risk of future cost of funding increases. Typically low, but higher than a swapped rate because of perceived credit risk to the borrower. May be initially lower than a traditional fixed rate but includes a symmetrical prepayment provision. Requires an upfront premium to purchase the interest rate cap. This can be costly depending on structure and term.
Flexibility Low: Usually, no portability and some form of prepayment penalties will apply. High: No prepayment penalty, but restrictions on future use and portability. High: Offers flexibility like a floating rate loan, with the option of portability and collateral substitution. But early prepay triggers symmetrical prepayment provision. High: Like floating rate loans, no prepayment penalty, but restrictions on future use and portability.
Best for… Borrowers who prioritize certainty are planning a long-term hold and believe that they will not benefit from future collateral substitution flexibility. Short-term holds (12–24 months), or for borrowers with a high-risk tolerance who can absorb potential payment volatility. Borrowers seeking the lowest current priced credit facilities, long-term hold, certainty of payments, and more flexibility for collateral substitution. Borrowers who want to benefit from potential rate drops but need protection from extreme rate spikes. It is a hybrid approach for balancing risk and reward.

The lender explained that there is no single “best” option, but the ideal choice is the one that best aligns with the client’s business goals and financial strategy.  The lender also emphasized some of the key considerations for the client, as follows:

  • Holding period: A shorter timeline of 1-2 years makes a floating rate or capped rate a more attractive option.
  • Market outlook: Do not rely on your expectations of future interest rates unless you have a proven history of being correct over many cycles.
  • Risk tolerance: Can your property/portfolio accommodate rising or volatile P&I payments, or do you prefer stability of payments? More conservative borrowers or properties with more volatile NOI/EBITDA will favor fixed or swapped rates, while those with higher risk tolerance may choose floating rates.
  • Cash flow sensitivity: Consider how your business’s or property’s cash flow would be affected by higher interest payments. Businesses with tight profit margins or less liquidity may prefer the stability of a swapped or fixed rate.
  • Lender requirements: Some lenders may require a fixed or swapped rate, or cap to ensure the borrower can meet debt service coverage ratio (DSCR) minimums in a rising rate environment. Most banks offer lower pricing for swapped loans because it minimizes interest rate risk for the bank – the savings of 50 to 100bps can make a significant difference to the borrower’s periodic loan servicing payments.

Conclusion

Advising commercial borrowers on loan structuring is a clear way to add value to a relationship. The act of understanding the various options, the risks and benefits is what can set a lender apart from the competition.

There is no right answer in every financing situation.  Further, some banks misprice the options discussed above by not pricing on the lending curve, or not correctly pricing optionality, convexity, default, or repayment risk – thereby negating the assumptions above that make loans priced on a floating index, fixed rate, swapped or capped all cost the same to the borrower.  However, lenders can enhance their value with a client and be indispensable trusted advisors by understanding the concepts above and being able to relay those concepts to their clients.

Tags: , , , , , , Published: 09/08/25 by Chris Nichols