Spread and Index | How Floating Rate Debt Is Actually Priced

Definition

A floating rate loan carries a rate that is recalculated periodically from two components.

The index. A published market benchmark neither party controls. In commercial real estate this is usually SOFR, the secured overnight financing rate, often in a term form such as one month or three month term SOFR. Some bank facilities and SBA variable rate lending reference the prime rate instead. The index moves with the market and resets on a defined schedule, monthly or quarterly being common.

The spread. The fixed margin the lender adds on top, quoted in basis points. This is the lender's price for the credit risk of that specific deal, and it is normally locked for the term.

All in rate = index at reset + spread

So a loan priced at term SOFR plus 350 basis points, with SOFR at 4.20 percent on the reset date, carries an all in rate of 7.70 percent until the next reset. If SOFR moves to 3.60 percent at the following reset, the rate becomes 7.10 percent. The spread stayed exactly where it was.

Basis Points, and Why Everyone Uses Them

A basis point is one hundredth of one percentage point.

- 25 basis points = 0.25 percent - 100 basis points = 1.00 percent - 350 basis points = 3.50 percent

The convention exists to kill ambiguity. If a lender says pricing improved by 0.25 percent, a borrower could reasonably read that as a proportional cut, taking 8.00 percent to 7.98 percent. Saying 25 basis points can only mean one thing: 8.00 percent becomes 7.75 percent. In documents and conversation it is abbreviated bps and spoken as bips.

On a $20,000,000 loan, 25 basis points is $50,000 a year. Small sounding numbers are not small.

Why a Headline From Rate Is the Wrong Comparison

Marketing sheets lead with a from rate because it is the most attractive single number available. Understanding what that number actually is makes it much less useful.

A from rate is normally:

- A fixed rate, even when the product being marketed is commonly floating - A best case, requiring the strongest sponsor, cleanest stabilized asset, lowest leverage, shortest term and best market simultaneously - A single point in time, often not refreshed as the market moves - Silent on structure, saying nothing about fees, prepayment provisions, recourse, floors or caps

A floating deal cannot be described by a single number, because it is a mechanism rather than a price. Setting a fixed from rate next to a floating structure is comparing an advertisement to a formula, and the comparison flatters whichever side chose the framing.

What to compare instead. On floating quotes: spread against spread, on the same index and the same tenor, then the floor, the cap requirement and cost, the reset frequency, and the fee stack. On floating against fixed: the modelled all in cost across the period you actually intend to hold the asset, at several plausible index levels, together with what it costs to get out early.

Floors, Caps and the Things That Move the Real Number

Two loans quoted at the same spread can behave very differently. The structural terms are where the difference lives.

Index floor. A contractual minimum applied to the index component. At SOFR plus 300 with a 2.00 percent floor, an index that falls to 1.40 percent still prices as though it were 2.00 percent: 5.00 percent all in rather than 4.40 percent. Floors protect lender yield in a falling market and are easy to miss when eyeballing quotes.

Rate cap. A purchased hedge limiting how high the index can go for the borrower. Above the strike, the counterparty covers the excess. Floating lenders, particularly on bridge and transitional debt, often require one at closing and again at extension. The cost is real, belongs in the deal budget, and moves with market conditions, so a renewal can price very differently from the original purchase.

Reset frequency. How often the rate recalculates. More frequent resets track the market more closely in both directions.

Index tenor. One month term SOFR and three month term SOFR are different numbers. A spread comparison across different tenors is not a like for like comparison.

Fees. Origination, exit, extension, unused line and administrative charges all sit outside the quoted rate and all affect what the money costs.

Prepayment provisions. Floating debt is often relatively open to prepay after a short lockout. Fixed rate debt, especially securitised, can carry defeasance or yield maintenance that makes an early exit expensive. If there is any chance of selling or refinancing early, this belongs in the comparison from the start.

The Test That Actually Decides It

The reason floating pricing matters beyond cost is that the rate drives the payment, and the payment drives the coverage test.

A deal that clears coverage comfortably at today's index can fail it after two resets in the wrong direction. Since the coverage test is checked at underwriting and, on many structures, monitored through the term with cash management or cash trap consequences, a borrower should always know the index level at which their coverage breaks, and hold that number in mind rather than the current one.

Coverage below 1.25x is the single most common reason a deal does not clear. In current commercial real estate conditions the debt yield test binds more often than loan to value does, and debt yield has a useful property here: it is calculated from net operating income and loan amount, so unlike a coverage ratio it does not move when the rate moves. That is exactly why lenders lean on it.

Pricing, structure and approval are the lender's decision. PeerSense is a capital advisory: we position a deal and place it with lenders whose credit box already fits it. We do not lend, fund, price or approve anything, and nothing here is a rate quote.