Variable Rate

Definition of Variable Rate Commercial Mortgages

A Variable Rate commercial mortgage, also commonly referred to as an adjustable-rate mortgage (ARM), is a long-term loan secured by commercial real estate where the interest rate fluctuates over time. Unlike a fixed-rate mortgage, where the interest remains constant for the duration of the term, a variable rate is tied to a specific financial benchmark or index. As the benchmark moves up or down, the borrower's interest rate and subsequent monthly payments adjust accordingly.

How Variable Rates are Calculated

The interest rate on a variable rate commercial mortgage is typically composed of two distinct parts:

• The Index: This is a neutral, third-party benchmark that reflects current market conditions. Common indices include the Secured Overnight Financing Rate (SOFR), the Prime Rate, or the Constant Maturity Treasury (CMT) rate.
• The Margin (or Spread): This is a fixed percentage added to the index by the lender. The margin remains constant throughout the life of the loan and represents the lender’s profit and compensation for risk.

The formula for the interest rate is: Index + Margin = Fully Indexed Rate.

Key Features and Protections

Variable rate commercial loans often include specific terms to manage the risk of extreme market volatility. These include:

• Adjustment Periods: This defines how often the interest rate changes. Common intervals include monthly, quarterly, or annually.
• Interest Rate Caps: These are limits on how much the rate can increase. A periodic cap limits the change between adjustment periods, while a lifetime cap limits the total increase over the entire life of the loan.
• Floors: A floor is the minimum interest rate a borrower will pay, regardless of how low the index drops. This ensures the lender maintains a basic level of profitability.
• Conversion Options: Some variable rate contracts allow the borrower to convert the loan into a fixed-rate mortgage at specific intervals, providing a hedge against rising interest rates.

Advantages of Variable Rate Mortgages

Variable rate loans are often attractive to commercial investors for several reasons. Initially, these loans typically offer lower starting interest rates compared to fixed-rate products. This can significantly improve a property's cash flow in the early years of the investment. Additionally, variable rate loans often come with lower prepayment penalties, providing the borrower with greater flexibility to refinance or sell the property without heavy financial friction. If market interest rates decrease, the borrower benefits from lower monthly payments without the need for a costly refinancing process.

Risks and Disadvantages

The primary disadvantage of a variable rate commercial mortgage is interest rate risk. If market rates rise significantly, the cost of debt increases, which can tighten a business’s cash flow and reduce the overall profitability of the commercial asset. This creates payment uncertainty, making long-term financial budgeting and forecasting more difficult for property owners and stakeholders. Because of this unpredictability, variable rate loans are generally considered higher risk than fixed-rate alternatives during periods of economic instability or rising inflation.