An interest rate swap is a derivative contract between two parties — typically a CRE borrower and a bank — in which they agree to exchange interest rate cash flows for a specified period. In the most common structure (a “plain vanilla” swap), the borrower agrees to pay a fixed rate to the bank, and the bank agrees to pay the borrower a floating rate (SOFR). When paired with a floating-rate loan, the swap effectively converts the borrower’s floating-rate obligation into a synthetic fixed rate: the floating payments from the swap offset the floating interest on the loan, leaving the borrower with a net fixed cost equal to the swap rate plus the loan spread. Swaps are governed by an ISDA Master Agreement and are executed for a notional amount that typically matches the loan balance.
How It Works in Practice
Interest rate swaps are the institutional-grade approach to hedging floating-rate CRE debt. Unlike caps, which only protect against rates exceeding a threshold, swaps lock in a known fixed rate — providing certainty but eliminating the benefit if rates decline. The key practical consideration with swaps is the termination cost: if you need to exit the swap early (because you’re selling the property, refinancing, or prepaying the loan), you must settle the swap’s mark-to-market value. In a falling rate environment, your swap has a negative MtM, meaning you owe the bank a termination payment that can run into the hundreds of thousands or millions of dollars. This termination cost functions like a prepayment penalty and must be factored into any disposition or refinancing analysis. Borrowers should also understand that swaps are separate contracts from the loan itself — the swap counterparty may be different from the lender, and the terms don’t always align perfectly. LoanBoss tracks swap terms, mark-to-market values, and termination exposure across your portfolio in partnership with Pensford’s advisory team.
Related Terms
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.