Understanding Floating-Rate Mechanics
A floating-rate CRE loan typically follows this formula: Interest Rate equals SOFR (or Prime) plus Spread. SOFR (Secured Overnight Financing Rate) is currently 4.25-4.35% and adjusts daily based on overnight secured lending markets. Your rate adjusts quarterly or annually depending on loan terms. The spread is the lender's margin-200-275 basis points for bank lenders or 275-350 basis points for non-banks-and this spread is fixed for the life of the loan.
A current example with a bank lender shows SOFR at 4.30% plus spread of 2.25% equals your rate of 6.55%. Next quarter if SOFR is 4.35% plus spread 2.25%, your rate becomes 6.60%. Simple, but what if SOFR jumps?
Rate Scenario Analysis
Under a conservative baseline with no rate changes, SOFR stays 4.25-4.35% and your rate is 6.5-6.85%, comfortable for lenders with normal DSCR requirements of 1.20-1.25x. In the base case with mild rate rise, SOFR rises to 4.75% over 18-24 months and your rate hits 7.0-7.25%, with DSCR stressed at 1.15-1.20x and lenders potentially requiring additional cash reserves.
In the stress case, SOFR rises to 5.25% (additional 100 bps total increase) and your rate hits 7.5-7.75%, with DSCR now at 1.05-1.10x (tight; refinancing becomes difficult). Many deals become underwater if NOI is flat. In the severe stress scenario of recession plus rate spike, SOFR reaches 5.75% (150 bps increase) and your rate hits 8.0-8.25%. Combined with NOI declining 10-15% from vacancy and tenant defaults, your DSCR drops to 0.95-1.05x. Refinancing becomes impossible; you face forced sale or default.
Cash Flow Impact: Numerical Example
Consider a $4M floating-rate loan at SOFR plus 225 bps, amortized 25 years, assuming NOI of $350K. At SOFR 4.25% (rate 6.50%), your monthly payment is $20,233 with annual debt service of $242.8K and DSCR of 1.44x. At SOFR 4.75% (rate 7.00%), monthly payment rises to $22,040, annual debt service to $264.5K, and DSCR falls to 1.32x. At SOFR 5.25% (rate 7.50%), monthly payment is $23,920, annual debt service is $287.0K, and DSCR drops to 1.22x. At SOFR 5.75% (rate 8.00%), monthly payment reaches $25,854, annual debt service is $310.3K, and DSCR falls to 1.13x. At SOFR 6.25% (rate 8.50%), monthly payment is $27,845, annual debt service reaches $334.1K, and DSCR is only 1.05x.
A 200 bps increase in SOFR (from 4.25% to 6.25%) increases your annual debt service by $91K-26% higher. Your DSCR drops from 1.44x to 1.05x. This is the stress test lenders use.
Lender Stress Testing Requirements
Most banks now stress test floating-rate loans at SOFR plus 100 bps, requiring your loan to have DSCR above 1.20x at this stressed rate. Many deals fail this test. Some use SOFR plus 150-200 bps stress scenarios requiring DSCR above 1.15x. This is extreme, but lenders want safety margin.
What this means for deal underwriting: If your deal has $350K NOI and you want a $4M floating-rate loan, your actual DSCR at current rates is 1.44x (passes), stressed DSCR at SOFR plus 100 bps is 1.32x (passes), at SOFR plus 150 bps is 1.22x (passes), and at SOFR plus 200 bps is 1.13x (tight; may not pass). Most banks will decline the loan unless you drop to $3.75M or improve NOI to $375K or higher.
Refinancing Risk: The Real Threat
You close on a floating-rate loan in 2026 at 6.5% with a 3-year balloon. In 2026, SOFR is 4.25% and your rate is 6.50%. In 2027, SOFR rises to 4.50% and your rate is 6.75%. In 2028, SOFR is 4.75% and your rate is 7.00%. In 2029, SOFR reaches 5.50% and your rate is 7.75%-the balloon comes due and you must refinance.
Now you need to refinance $3.8M (after 3 years of amortization) at market rate of 7.75% minimum, but fixed rates might be 8.0-8.25% (lenders demand premium for longer terms). Your payment jumps another 2-3%. Lenders look at actual NOI (not pro forma). If market weakness exists, they approve only 65% LTV instead of 75%. You now have a $3.8M loan on a property worth $4.8M if valued at reduced cap rate. Refinancing is approved but painful. In the worst case, rates spike and market softens simultaneously. SOFR hits 6.0%, your floating rate hits 8.25%, and lenders won't refinance at high LTV due to credit quality concerns. You're forced to bring $300-500K equity to refinance or sell at a loss.
Key Insight: Floating-rate savings of 50-75 bps upfront look attractive but are offset by refinancing risk (50-100 bps additional cost if rates higher), stress testing requirements (lower LTV approval), and opportunity cost of uncertainty.
When Floating-Rate Loans Make Sense
Floating works best for short-term holds of 2-3 years with planned exit. You close at 6.5%, own for 2 years, and sell before balloon comes due. Refinancing risk is zero. Floating also works well on properties with strong NOI of 8% or higher with upside potential. Even if SOFR rises 150 bps, DSCR stays 1.20x or higher and you can refinance if needed.
Floating rates make sense if you believe rates are about to fall-rare in 2025-2026. Some floating-rate lenders allow you to step down to fixed rate at specific intervals (year 2, year 3), giving you optionality. If rates haven't risen, stay floating. If rates spike, lock fixed.
When Fixed-Rate Loans Are Better
Fixed rates are better for long-term holds of 7-10 years where certainty matters. Your debt service is locked and you model returns confidently. Fixed also works when cash flow is marginal with baseline DSCR of 1.20-1.25x-floating-rate risk is too high. Fixed is appropriate when 30% or more of leases expire in the first 5 years since you have refinancing uncertainty already. Fixed is necessary when you can't absorb rate shocks-if a 100 bps increase would force you to sell, you can't handle floating-rate risk.
Rate-Lock Hedging Options
You can enter interest rate swaps to convert floating rate to fixed without changing loan documents. Cost is 0.5-1.0% upfront and the effect is you pay fixed while lender pays floating. Advantage: maintains loan flexibility and you can exit swap if rates fall. Disadvantage: upfront cost reduces savings from floating.
Interest rate caps let you cap your floating rate at a ceiling (e.g., SOFR plus 2.25% equals max 7.0% rate). Cost is 0.75-1.5% upfront. When SOFR rises, your rate rises only until hitting the cap. Protects against worst-case scenario while still benefiting if rates fall. Disadvantage: cost reduces upfront savings.
Building Floating-Rate Risk into Your Model
Step one: Calculate current DSCR assuming current floating rate of SOFR 4.25% plus spread 2.25% equals 6.5%, with DSCR of $350K NOI divided by $243K annual debt service equals 1.44x. Step two: Stress test SOFR assumptions with conservative case (SOFR stays 4.25-4.50% over 5 years), base case (SOFR rises to 5.0% by year 3), and stress case (SOFR rises to 5.75% by year 3).
Step three: Model refinancing scenarios. At year 3 (balloon date), what if rates are 8.0% or higher? What if lenders only go 70% LTV instead of 75%? Can you cover the shortfall with additional equity? Step four: Set minimum DSCR thresholds. Stressed DSCR must stay above 1.15x. If it drops below 1.15x in stress scenario, refinancing is difficult and fixed-rate should be considered instead.
The Bottom Line on Floating-Rate Risk
Most successful CRE investors use floating rates only for short-term holds of 2-3 years with planned exit, properties with exceptional NOI of 8% or higher, or deals with immediate value-add and planned refinance in 18 months. For longer holds or marginal cash-flow properties, the 75-100 bps cost premium for fixed-rate is cheap insurance.
Frequently Asked Questions
If I lock fixed at 7.25% now, what rate should I expect in 2 years?
Likely 7.5-8.0% for 10-year fixed. Fed has signaled 4.0% plus is neutral. Rates won't drop meaningfully before 2027.
Can I convert a floating-rate loan to fixed mid-term?
Yes, via interest rate swap (cost 0.5-1.0% upfront). Or ask lender about conversion option when originating loan.
What DSCR do lenders require for floating-rate stress?
Most require 1.20x DSCR at SOFR plus 100 bps. Some require 1.15x at SOFR plus 150 bps. Ask upfront.
Should I take floating if I'm planning to hold 3 years?
Yes, if balloon is at year 4-5. Floating saves 50-75 bps over 3 years equals $40-60K. Refinancing risk is low since you haven't hit balloon yet.