Underwriting Floating Interest Rate Debt

Depending on the market and business plan, many sponsors utilize floating interest rate loans for their projects. A floating interest rate refers to a variable interest rate that changes over the duration of the debt obligation.

The total interest rate moves up and down, or “floats,” reflecting economic or financial market conditions. Often, it moves in tandem with a particular index or benchmark, or with general market conditions.

Let’s take a look at how to accurately underwrite a floating interest rate loan.

What is SOFR? 

SOFR Forward Curve

Please note: The above table is an example and may not depict the most recent SOFR Index.

The Secured Overnight Financing Rate (SOFR) is an influential interest rate that banks use to price U.S. dollar-denominated derivatives and loans.

SOFR took the place of LIBOR in June 2023, offering fewer opportunities for market manipulation and current rates rather than forward-looking rates and terms.

SOFR is a common benchmark used in commercial real estate financing for floating interest rate debt. A lender will quote the borrower’s interest rate comprised of:

Lender Spread + SOFR = Total Interest Rate

SOFR & Underwriting

To underwrite a floating interest rate loan, you will need to incorporate the latest SOFR forward curve into your underwriting model. This can be downloaded for free on Chatham Financial.

Keep in mind, the SOFR projections are constantly changing!

Please note: The above table is an example and may not depict the most recent SOFR Index.

Follow these steps to input floating interest rate debt into an underwriting model:

  1. Download the latest SOFR Curve Excel file
  2. Copy & paste values into underwriting model
  3. Input the Lender Spread

Now your projected interest rate in the underwriting model will accurately reflect the SOFR Curve + the Lender Spread input. As SOFR moves up or down, the required debt service will change.

Best Practices

As noted, the SOFR Curve (and all benchmarks) are constantly changing. Lenders, economists, and experienced investors do not have a crystal ball to predict what will happen in the market. Nobody knows how accurate the projected forward curves will be.

The purpose of creating an underwriting model, with floating interest rate capability, was to provide as much flexibility as possible to the user.

If you choose to model a floating interest rate loan, be sure to understand the risks involved. Best practices would include adding a buffer of 100 – 200bps to your interest rate, so hopefully the rate shown is higher than what you actually receive.

The Next Level Value-Add Model allows for fixed and floating interest rate loans on the senior loan and refinance loan.