Comparing a fixed-rate loan with floating debt plus a hedge

A fixed-rate mortgage, floating debt with a cap and floating debt with a swap can all limit rate risk in different ways. The decision should compare funded proceeds, payments, upfront cash, principal remaining and exit obligations over the same ownership period. Comparing a fixed coupon with a cap strike or a displayed swap rate skips essential parts of the financing.

Start with the business plan and required cash resilience. The owner may value a stable budget, benefit from lower rates, expect an early sale or need a loan that accommodates changing balances. Those preferences should be reflected in complete financing alternatives, with the lender's actual permitted hedge structures confirmed.

Define what is fixed in each proposal

A fixed-rate loan establishes its contractual rate for its stated period, subject to its documents. A matching pay-fixed swap can offset a floating benchmark but is a separately documented obligation. A cap limits specified benchmark exposure above its strike while retaining floating exposure below it.

Chatham's swap FAQ distinguishes swap and cap economics and explains that pricing components and early termination matter.^[1] Do not compare a swap's fixed benchmark component with a mortgage's all-in coupon. The loan spread and any quote components need to be identified. The FAQ also explains that an unmatched loan floor can increase the combined cost when the benchmark falls below that floor.^[1]

Chatham's cap guide identifies notional, term and strike and describes the upfront premium.^[2] The strike is not the all-in loan rate. Add the applicable spread, account for the floor and check matching conventions before stating the protected payment ceiling.

Normalize proceeds and principal

Use a common funded amount first to understand cost differences. Then show each actual proposal's proceeds and liquidity separately. A loan with a lower rate but smaller advance can require more equity; a higher advance can increase payments despite a lower rate.

Consider an original hypothetical $96 million interest-only principal and a three-year comparison period. Assume a fixed coupon of 6.35%. The alternative floating loan has a 2.1% spread and 2% benchmark floor, with a fully matching three-year cap at a 4.5% strike costing $1 million.

A third alternative uses the same floating loan and a fully matching swap paying 4.05%, producing a 6.15% combined profile while the floor does not interfere. Assume the floor is properly matched or otherwise addressed under approved terms. These rates, premiums and fees are invented comparison inputs, not market quotes or program offers.

All three structures are assumed to retain $96 million of principal for this comparison. In an actual transaction, replace that assumption with each amortization schedule and reconcile the terminal balance. Financing cost and principal repayment should remain separate so amortization does not falsely appear to be an extra expense.

Compare a complete illustrative rate path

Assume annual benchmark settings of 6%, 3.5% and 2.25%, each lasting a simplified 360-day year. The capped loan's net rates are 6.6%, 5.6% and 4.35%, respectively. Its interest totals $15.888 million over the three years, plus the $1 million premium.

Fixed interest is $18.288 million. Matching swapped interest is $17.712 million. Assume transaction costs of $900,000 for the fixed structure and $700,000 for each floating structure. Before exit costs, the totals are $19.188 million fixed, $17.588 million capped and $18.412 million swapped.

The capped structure appears least expensive on this invented path. That does not predict its expected return or establish that floating debt will outperform. It makes the assumptions visible, so ownership can judge whether the property can absorb less favorable paths and whether flexibility warrants the premium.

Freddie's floating-rate sheet specifies its own index, accrual, cap and prepayment provisions.^[3] A real comparison must use the proposed execution's conventions rather than these simplified annual settings. Rate changes within a year, actual/360 calendar effects and receipt timing can alter cash outcomes.

Add the expected exit event

Suppose the owner sells after the comparison period and obtains transaction-specific estimates of $1.6 million of fixed-loan exit costs, $2.4 million of swap termination costs and no additional exit charge for the assumed capped-loan structure. These are illustrative scenario amounts, not derived hedge valuations or general product features.

Including those amounts gives $20.788 million for fixed debt, $20.812 million for swapped debt and $17.588 million for capped debt. The swap's lower payment did not make it cheaper than the fixed structure in this exit scenario. Different market conditions or documents can reverse the outcome.

Freddie's fixed-rate sheet describes particular lockout, yield-maintenance and defeasance provisions.^[4] It does not establish the exit amount for an unrelated fixed loan. Obtain the relevant payoff or defeasance process and date-specific estimates for the actual proposal.

Chatham's swap FAQ explains that early termination can require a payment or produce a receipt depending on contract and replacement conditions.^[1] Model both directions and record whether payoff requires settlement. A swap is not automatically free to exit because the underlying mortgage is floating.

Test the alternatives' cash ceiling

If the benchmark stays at or above 4.5% in all three simplified years, the matching capped structure produces $19.008 million of net interest. Adding its $1 million premium and $700,000 transaction costs gives $20.708 million before any unlisted charges. The cap limits specified benchmark exposure under the matching assumptions; it does not protect property NOI.

At benchmark settings of 2% or below, the hypothetical loan floor produces a 4.1% rate. Three-year interest would be $11.808 million, plus $1.7 million of premium and costs, or $13.508 million. This lower-rate result still depends on the stated floor and cap terms.

Chatham's cap pricing discussion explains that the premium varies with economic terms, market rates and volatility.^[2] The owner's tradeoff is protection purchased upfront versus a different payment profile and exit obligation. Do not treat the original premium as a recurring rate or assume a shorter renewal will have a proportionately smaller cost.

Preserve liquidity for gross payments and upfront cash

Identify when the cap premium is paid, when swap settlements occur and whether the lender nets receipts or requires gross loan payments first. Include initial reserves, later hedge deposits and operational timing gaps in the capital budget. Equal net annual interest can coexist with different cash needs during the month.

Freddie's floating-rate sheet includes reserve and cap-related requirements for its execution.^[3] Compare those items with the actual fixed proposal. A restricted reserve is not the same economic item as a paid transaction fee, though both can reduce cash available at closing.

Choose with a record containing common-period cash flows, actual proceeds, base and stressed income, hedge conventions and alternative exit dates. State what the owner is paying for: a stable rate, a defined ceiling, participation in lower rates or greater exit flexibility. The preferred debt structure should fit those objectives through the property's holding and repayment plan, not merely win a comparison of headline rates.