Back to Articles

Fixed vs. variable rate loans in Australian commercial real estate financing

In the dynamic landscape of commercial real estate financing in Australia, investors and borrowers are presented with a choice between fixed rate and variable rate (also known as floating rate) loans, often sourced from non-bank financial institutions or alternative lenders. Understanding the nuances of these financing options, particularly when variable rates are tied to benchmarks like the Bank Bill Swap Rate (BBSW) or the Reserve Bank of Australia (RBA) Cash Rate, is crucial for making informed decisions.

Fixed rate Loans: The Beacon of Predictability

Fixed rate loans stand out for their stability and predictability. In these deals, borrowers are locked into a predetermined interest rate for the duration of the loan, ensuring consistent repayment schedules. However, there are usually a few circumstances where a lender has the ability to increase the fixed interest rate. For example, if there is a default event and the borrower has not paid the agreed interest amount by a due date, then the lender can increase the fixed rate by a nominal percentage, typically around 4%, which is usually called the default rate.

The fixed rate is particularly advantageous for commercial real estate property developers who prioritise budgeting certainty and risk minimisation. This holds especially true in the current residential market, where a record number of Australians are at risk of mortgage stress, should interest rates continue to raise in 2024. As a fixed rate loan facility will not increase during the duration of the loan term, those who have opted for them will feel safer against RBA Cash Rate increases.

Pros:

• Certainty and stability: Fixed rates guarantee the same interest rate and monthly repayments, facilitating easier long-term financial planning.

• Protection from rising interest rates: Borrowers are shielded from any future rate increases, potentially saving significant costs over the loan term.

• Simplicity: The straightforward nature of fixed rate loans makes them accessible and easy to comprehend for most borrowers.

Cons:

Higher initial rates: Typically, fixed rates are set higher than variable rates at the outset to compensate lenders for the risk of future rate fluctuations.

Reduced flexibility: Fixed rate loans offer less leeway for benefiting from falling interest rates, as borrowers are tied to their initial rate.

Prepayment penalties: Early loan repayment can incur substantial penalties, as lenders lose out on expected interest earnings. However, to mitigate this, minimum term clauses are usually set out in the Loan / Facility Agreement between the lender and the borrower. The minimum term sets out the minimum number of months / days that the borrower needs to pay interest, regardless of whether the borrower has repaid the loan earlier. For instance, if a borrower has a minimum term of 6 months on a 12-month loan term, then the borrower needs to pay interest for at least 6 months even if the borrower repays the loan before 6 months.

Variable Rate Loans: Embracing Flexibility and Market Dynamics

Variable or floating rate loans, conversely, adjust their interest rates in accordance with market benchmarks, notably the BBSW or the RBA Cash Rate. The BBSW is determined by the Australian Stock Exchange (ASX) using a predetermined methodology, but at its essence, the BBSW can be simplified as the rate at which bank bills are traded among major banks in Australia, reflecting the short-term lending rates for periods ranging from one month to six months. In contrast, the RBA Cash Rate is set by the Reserve Bank of Australia with several factors taken into consideration.

For several non-bank lenders, the BBSW serves as a cornerstone for setting interest rates in floating rate deals. It offers a transparent mechanism to adjust interest rates for variable loans, reflecting the current trading rates of bank bills among Australia's major banks. This benchmark is instrumental in floating rate private credit deals, where the interest component varies with the BBSW or the RBA Cash Rate depending on the non-bank lenders' policy, plus a set margin that remains constant over the loan term.

For instance, a loan structured as "1-month BBSW + 5%" means the borrower's interest rate for any given month will be the 1-month BBSW rate at the start of that month plus a 5% margin. This structure offers a blend of market responsiveness through the BBSW component and predictability with the fixed margin.

Pros:

• Lower starting rates: Initial rates for variable loans are often lower compared to fixed rate loans, offering initial cost savings.

• Potential for rate decreases: Borrowers can benefit from reduced repayments if benchmark rates decline.

• Greater flexibility: These loans usually allow for extra repayments without significant penalties, offering more control over the loan.

Cons:

• Repayment uncertainty: The fluctuating nature of variable rates complicates budgeting due to unpredictable repayment amounts.

• Risk of increased repayments: Should the benchmark rates rise, so will the loan repayments, affecting borrowers' financial planning.

• Complexity: Keeping abreast of market dynamics and understanding the factors influencing variable rates requires more effort and knowledge.

Strategic Considerations for Borrowers

The decision between fixed and variable rate loans for commercial real estate financing hinges on several key factors, including risk tolerance, market outlook, and financial strategy. Variable rate loans, with their linkage to the BBSW or RBA rates, provide an opportunity for cost savings in a declining interest rate environment but come with the risk of increased repayments if rates rise. Fixed rate loans eliminate such uncertainty, offering a stable financing cost regardless of market fluctuations.

Given the competitive margins typically ranging from 4% to 8% above the BBSW / RBA rate, non-bank or alternative lenders can become more attractive compared to bank rates in a rising interest rate scenario. These dynamic underscores the importance of understanding both the market environment and the specific terms of fixed and variable rate loans when navigating the complex landscape of commercial real estate financing in Australia.

In conclusion, whether opting for the predictability of fixed rate loans or the flexibility and potential savings of variable rate loans, commercial real estate borrowers must weigh their options carefully. Understanding the role of benchmarks like the BBSW in floating rate deals is crucial for informed decision-making, ensuring that the chosen financing strategy aligns with investment objectives and market dynamics.

Image by Thongchai Tokvamroo from Pixabay