Floating Rate Debt

Floating Rate or Variable Rate debt, refers to a form of financing where the interest rate used to calculate the interest due in each period changes (i.e. varies or floats) periodically. The interest rate for a floating rate loan is generally calculated by taking a regularly-changing benchmark rate (e.g. LIBOR, SOFR, Government Bonds, etc), and adding some premium to that rate to arrive at a periodic interest rate. Floating Rate debt is in contrast to Fixed Rate debt, where the interest rate does not change.

So for instance, imagine that the annual interest rate on a floating rate loan is calculated each month by taking the One Month LIBOR and adding 200 bps (i.e. 2.00%) to arrive at the periodic interest rate. If in month one the One Month LIBOR was 0.50%, than the annual interest rate for purposes of calculating the interest due in month one would be equal to 0.50% + 2.00% = 2.50%.

Further imagine that from month one to month two, the LIBOR rate increased from 0.50% to 0.60%. For purposes of calculating interest in month two, the annual interest rate would increase from 2.50% to 2.60% (0.60% + 2.00%).

Putting “Floating Rate Debt” in Context

The Santos Family, owners of Madison Plaza Tower, a 45-story, 800,000 square foot Class A office building in Manhattan’s Central Business District (CBD), are facing a temporary issue. Due to recent lease expirations, the building’s occupancy has dropped to 77%, leaving significant vacancy in an otherwise high-demand market. The building has a long history of stable performance, and the family is confident that with time, they will re-lease the vacant space and bring occupancy back to its historical levels of 95-100%.

However, the Santos Family’s current financing is coming due, and the property’s lower occupancy makes it difficult to qualify for long-term, fixed-rate financing. To bridge the gap between the current underperformance and future stabilization, the family decides to secure floating-rate bridge debt from Cresthill Capital, a lender specializing in transitional assets.

The Floating Rate Bridge Loan

The Santos Family takes out a $75 million floating-rate bridge loan. This type of loan has a shorter term (typically 2-3 years) and allows the borrower the flexibility needed to stabilize a property before refinancing into a long-term, fixed-rate loan. In this case, the loan from Cresthill Capital has an initial term of 3 years with an option to extend by an additional 12 months if necessary.

The interest rate on this loan is floating, meaning that it is tied to a changing benchmark, such as SOFR (Secured Overnight Financing Rate). Cresthill Capital prices the loan at 300 basis points (bps) over SOFR. At the time the loan is originated, the SOFR rate is 1.50%, so the initial interest rate on the loan is:

Initial Interest Rate = SOFR (1.50%) + 300 bps (3.00%) = 4.50%

This 4.50% interest rate will fluctuate as the SOFR rate changes over the loan term. If SOFR rises to 2.00%, for instance, the loan’s interest rate would adjust upward to 5.00% (2.00% + 3.00%).

Benefits of Floating Rate Debt

For the Santos Family, this floating-rate bridge loan is ideal because it gives them the flexibility they need during a transitional period. While the property is underperforming with 77% occupancy, the floating rate loan allows them to avoid locking in a higher fixed rate that would typically come with a more conservative lender’s underwriting on a low-occupancy property.

The bridge loan also comes with interest-only payments, which means the family is only required to pay the interest on the loan during the stabilization period, which helps them conserve cash flow while focusing on leasing up the vacant space.

Risks of Floating Rate Debt

However, with the flexibility of floating-rate debt comes interest rate risk. If SOFR or other benchmark rates increase over the loan term, the Santos Family will face higher interest payments. For instance, if SOFR increases from 1.50% to 3.00% over the next year, their interest rate will increase from 4.50% to 6.00%. At that point, their annual interest payment would increase accordingly:

Annual Interest Payment = $75 million × 6.00% = $4.5 million

This compares to the initial interest payment of:

Initial Annual Interest Payment = $75 million × 4.50% = $3.375 million

This volatility introduces uncertainty to their debt service costs, and if market rates rise too quickly, it could put pressure on their cash flow while they work to lease up the building.

The Long-Term Plan: Refinancing into Fixed Rate Debt

Once the Santos Family successfully brings the property’s occupancy back up to 95-100%, they plan to refinance out of the floating-rate bridge debt into long-term, fixed-rate debt, similar to the scenario in the companion case study. By doing so, they will eliminate the interest rate risk and secure stable debt service payments over the long term, matching the now-stabilized property’s predictable cash flow.

For example, if they successfully stabilize the property and market conditions remain favorable, they may qualify for a 10-year fixed-rate loan at a competitive spread over the 10-year U.S. Treasury rate—similar to the scenario where they refinanced at 5.70%.

Conclusion

In this case, the Santos Family’s decision to secure floating-rate bridge debt is a strategic move that allows them to bridge the gap between a temporarily underperforming asset and future stabilization. While floating-rate debt introduces interest rate risk, it provides the flexibility needed to manage a transitional asset like Madison Plaza Tower. Once they stabilize the property, the family plans to transition into more predictable fixed-rate debt, locking in long-term stability for their high-performing office building.

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Frequently Asked Questions about Floating Rate Debt

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