Interest rates might seem high now, but they are nothing compared to the 1980s. The average rate for a loan in 1981 was 16.5 percent, making it hard for most people to afford to buy a house. Back then, after years of raising interest rates to combat rampant inflation, there was a sense that the federal government was going to start easing rates back down. Understandably borrowers did not want to lock themselves into those high rates for the long term so to help people buy homes (and keep the real estate industry afloat) a new mortgage product was introduced. Adjustable-Rate Mortgages, or ARMs, started to be offered by banks across the country. These loans would help people buy houses they needed today without worrying about refinancing later as rates inevitably dropped.
The popularity of ARM loans spurred the creation of similar products in the commercial property industry. Floating-rate loans have slowly become more common for commercial borrowers over the past few decades but their popularity spiked as rates got pushed down to almost nothing during the financial crisis in 2008. For the 10 years that followed the Great Recession, rates stayed low, making floating-rate loans a good choice. But then inflation started to rear its ugly head and the Fed acted quickly to tame it. Now people locked into floating-rate loans are having a hard time making their payments.
A loan, whether it is fixed or floating, is a bet. If you take out a fixed loan you are betting that rates will go up, if you sign a floating-rate loan you are betting that they will either stay the same or go down. With everything else being equal, floating-rate notes tend to be cheaper since the banks have less risk of markets changing. This makes floating-rate loans an even more enticing option “It made sense to take a floating rate because it was the cheapest cost of capital,” said Aaron Jodka, Research Director of U.S. Capital Markets at Colliers.
But inflation has been stickier than most economists predicted and has caught some people off guard. That has scared many borrowers away from floating-rate loans. “We are seeing more fixed-rate loans getting funded, even for hospitality properties, which historically prefer floating,” Jodka said. Rather than risk seeing rates climb higher, borrowers are opting to lock rates in. This might seem a bit counterintuitive since the Fed has announced that it will likely curtail rate hikes for the time being as long as current conditions remain. The promise of rates remaining the same is not enough for most borrowers, especially since it is so hard to predict when rates will go back down.
Usually demand is greatest for 10-year fixed-rate loans, which allow borrowers to lock rates in for an entire decade, but that too seems to be changing. “There is strong demand for loans with five-year terms, even CMBS [commercial mortgage-backed securities] have come out with five-year terms when they have historically been 10,” said Jodka. This demand for shorter-term loans shows that there is confidence that rates will go down, just not any time soon. We have seen the same thing play out with bonds where there is more of a market for short-term bonds than long-term ones, opposite of what we see in “normal” periods or interest and inflation.
The preference for fixed-rate commercial loans doesn’t mean that floating rate has completely fallen out of favor. “While all interest rates have been up over the last year, long-term rates have been volatile in recent months,” said Tim Milazzo, founder of StackSource, a marketplace for debt and equity for commercial properties. That volatility, plus the promise that rates will go down, is still enticing borrowers with more appetite for risk (and the reward that goes with it). “We are seeing less experienced borrowers desire to lock in a fixed rate now, while more experienced borrowers seem fine taking a floating rate,” Milazzo said.
The switch back to fixed-rate debt is likely a good thing for the health of the industry. ARMs were one of the reasons that the financial system collapsed in 2008. But they also represent the unfortunate state of lending. As much as we would all like to think that rates will go back down and reinvigorate the economy, the risk of that not happening is too much for most borrowers to bet on. There will be plenty of people that will still see opportunity in floating-rate mortgages, but the consensus for now seems to be that they are not worth the risk.