Interest Rate Swaps & How to Use Them

Interest Rate Swaps & How to Use Them

Interest rate volatility can have a major impact on commercial real estate financing. When borrowers choose a floating-rate loan, they often gain flexibility, faster execution, and sometimes a lower initial rate. The tradeoff is uncertainty. If short-term rates rise, debt service can increase quickly and put pressure on cash flow, debt service coverage, and investment returns.

One of the most common tools used to manage that risk is an interest rate swap. Swaps are widely used by sophisticated borrowers, investors, and lenders to convert floating-rate exposure into a more predictable fixed-rate obligation. For commercial property owners, understanding how swaps work can help with refinancing decisions, acquisitions, bridge-to-permanent strategies, and portfolio risk management.

This guide explains what interest rate swaps are, how they work, when they may make sense, and what commercial real estate borrowers should consider before using them.

What Is an Interest Rate Swap?

An interest rate swap is a financial contract in which two parties exchange interest payment obligations based on a notional amount. In commercial real estate lending, the most common structure is a borrower swapping a floating interest rate for a fixed rate.

In simple terms, the borrower keeps the underlying floating-rate loan, but enters into a separate swap agreement with a counterparty, usually a bank. Under the swap:

• The borrower pays a fixed rate to the swap counterparty.
• The counterparty pays the borrower a floating rate tied to an index such as SOFR.
• That floating receipt is intended to offset the floating interest due on the loan.

The practical effect is that the borrower’s floating-rate loan behaves much more like a fixed-rate loan, subject to the exact structure of the hedge and any spread differences.

How an Interest Rate Swap Works

Suppose a borrower closes a commercial mortgage with a variable rate of SOFR plus a lender spread. The borrower is concerned that rates may rise over the next three years. Instead of refinancing into a permanent fixed-rate loan, the borrower may enter into a swap that fixes the index portion of the debt.

The loan and the swap are separate agreements, but they are designed to work together. The borrower still makes loan payments to the lender and swap payments to the hedge provider. When structured properly, the floating-rate payments received under the swap offset the floating benchmark exposure on the mortgage.

Basic Example

• Loan amount: $10,000,000
• Loan rate: SOFR + 2.50%
• Swap fixed rate: 4.00%

If the swap is structured to hedge the SOFR component, the borrower effectively pays:

• 4.00% fixed under the swap, plus
• 2.50% lender spread on the loan

That results in an effective all-in rate of approximately 6.50%, excluding fees, credit adjustments, and other transaction costs.

Why Commercial Borrowers Use Interest Rate Swaps

Interest rate swaps are primarily used to manage risk. In periods of rising rates, they can help protect a property’s net cash flow and preserve underwriting metrics. They are especially useful for borrowers with floating-rate bridge loans, construction debt, or short- to medium-term financing that may later be refinanced.

Common reasons to use a swap include:

• Payment certainty: Stabilizes debt service for budgeting and forecasting.
• Cash flow protection: Reduces exposure to rising benchmark rates.
• Refinancing flexibility: Allows a borrower to keep a floating-rate structure while managing rate risk.
• Portfolio management: Helps owners manage exposure across multiple loans and properties.
• Execution advantages: May allow use of a floating-rate loan product that better fits the business plan.

Swaps vs. Fixed-Rate Loans

A swap can create a fixed-rate effect, but it is not the same as closing a true fixed-rate commercial mortgage. A fixed-rate loan generally has one loan agreement and one payment stream. A swapped loan involves both the mortgage and a separate derivative contract.

For borrowers comparing loan options, it is often wise to review both fixed-rate permanent financing and floating-rate execution with a hedge. For many properties, solutions such as commercial loans, conventional mortgages, or commercial loan refinance structures may offer alternatives depending on timing, business plan, and risk tolerance.

When an Interest Rate Swap May Make Sense

Swaps are often used when a borrower wants the benefits of a floating-rate loan but does not want open-ended exposure to future rate increases. They may be appropriate in situations such as:

• Bridge financing for a lease-up or repositioning: The property is not yet ready for long-term permanent financing, but rate risk needs to be controlled.
• Construction loans: Borrowers may hedge anticipated interest exposure during the build period.
• Value-add strategies: The borrower plans to refinance or sell after improvements are completed.
• Portfolio loans: Owners with multiple variable-rate properties may want to reduce overall interest rate sensitivity.
• Uncertain rate environment: A swap can help lock in borrowing costs when market rates are rising or volatile.

Key Risks and Considerations

Interest rate swaps can be effective, but they are not simple products. Borrowers should understand the following issues before entering into one:

Basis Risk

The floating rate on the swap must align closely with the floating rate on the loan. If the indices or reset mechanics do not match, the hedge may be imperfect.

Termination Costs

If a loan is prepaid, refinanced early, or otherwise modified, the swap may also need to be terminated. Depending on market conditions, that termination may result in a significant cost or, less commonly, a gain.

Counterparty Risk

Because the swap is a contract with a financial institution, the borrower is exposed to the credit quality and performance of that counterparty.

Documentation and Complexity

Swap agreements involve specialized legal documents, operational procedures, and collateral terms in some cases. Borrowers need qualified legal and financial guidance.

Notional Amount and Amortization Matching

The hedge should be sized and timed to fit the loan balance, draw schedule, or expected amortization. A mismatch can create over-hedging or under-hedging.

Interest Rate Swaps vs. Interest Rate Caps

Borrowers often compare swaps to interest rate caps. Both are hedging tools, but they work differently. A swap effectively converts floating-rate exposure into a fixed-rate obligation. A cap, by contrast, sets a maximum benchmark rate but allows the borrower to benefit if rates decline.

• Swap: Greater payment certainty; less ability to benefit from falling rates.
• Cap: Protection above a strike rate; borrower still has floating-rate exposure below the cap.

Caps are common with bridge and floating-rate commercial mortgages, while swaps may be preferred when a borrower wants stronger budget certainty over a defined term.

How to Evaluate Whether a Swap Is Right for Your Loan

Before using an interest rate swap, borrowers should evaluate both the financing strategy and the property’s operating profile. Questions to ask include:

• How long do you expect to hold the property or keep the loan?
• Is the property’s cash flow stable enough to support rate volatility without a hedge?
• Would a fixed-rate permanent loan be more appropriate?
• What are the all-in costs of the swap, including fees and potential breakage?
• Does the hedge term align with the expected refinance or sale timeline?
• How will the swap affect prepayment flexibility and exit strategy?

It can also be helpful to model different rate scenarios using underwriting tools such as a Commercial Mortgage Calculator, DSCR Calculator, NOI Calculator, and current Commercial Loan Rates.

Practical Takeaway for Commercial Real Estate Borrowers

Interest rate swaps can be powerful risk-management tools for commercial real estate borrowers, especially when financing involves floating-rate debt. They can bring predictability to debt service, support underwriting stability, and help borrowers execute business plans that require short- or medium-term variable-rate financing.

At the same time, swaps add complexity. They are not one-size-fits-all solutions, and they must be carefully matched to the loan structure, hold period, and exit strategy. Borrowers should weigh the benefits of certainty against the costs, documentation, and potential termination exposure.

For owners considering bridge, construction, refinance, or permanent financing options, comparing the full range of fixed-rate and floating-rate structures is essential. A well-structured loan and hedge strategy can help protect cash flow while preserving flexibility in changing interest rate environments.