Dean Egerter, a principal with Chicago - based Harrison Street Capital, says floating-rate debt is best for borrowers who know a distressed property can be made better. "Let's say I have a multifamily asset with $50 million in financing," he says. "I get into the floating-rate market as a borrower with Libor plus 300 basis points, say the interest costs on a 3.5% rate would be about $1.7 million. If I get that same financing on a fixed basis, the rate would be 5%, about a $2.5-million interest payment. I can take that $700,000 saved doing a floating rate and use it to build cash for the eventual modification."

Many of these float deals had extensions as well, up until now. Hugh Hall, managing director of Horsham, PA-based Berkadia, tells DAI that, with most distressed loans, it's taken lenders and special servicers some time to gear up and figure out how to handle floating rate maturities effectively; it's been easier just to approve extensions. "These loans have been coming due for the past several years, and regulators have given a free pass for banks to extend and pretend," he says.

However, as we know, the default rate has become enormous, proof that many of the properties are not as stable as borrowers and lenders had hoped. Chris Carroll, managing director of capital markets for Chicago-based Cohen Financial, tells DAI that he talks to floating-rate borrowers every day who are nervous about the future. "Everybody's realized that they're cheating death," he says. "You have to ask yourself if it is better to get long-term financing, or act like a gambler addicted to low rates because of the cash flow. It's not the rate today, it's the maturity."

Kevin Smith, head of capital markets for New York City-based Centerline Capital Group, says that many of these floating-rate deals took advantage of aggressive underwriting up until 2007, based on projected stabilized pro-formas. "Many of these properties haven't realized this expectation," he says, "and the value of the real estate has deteriorated. Now the debt is coming due, and they're having trouble financing out." Following the current national commercial real estate trend, the floating-rate market is clearly a case of have and have-nots. If the property in question is stable, or has the potential to stabilize, there's a tremendous amount of capital waiting on the sidelines, explains Smith. Conversely, if a property is not stable, the borrower will see no interest at all from lenders. "There's tremendous competition to acquire good assets today," he says. "The capital market has recovered."

Floating-rate bond funds increased their purchasing from almost $19 billion in 2010 to almost $14 billion just in Q1 '11, according to Lipper Inc. In fact, floating-rate debt provided across multiple sectors is one of the top producers of returns for investors, with an average 2% gain in the first quarter. Traditionally, floating debt investment has beaten bond returns. Both New York City based JPMorgan Chase and Frankfurt, Germany-based Deutsche Bank are now working on securitizing about $350 million of floating-rate loans.

Eric Meyer, head of the Deutsche Bank US loan group, said in a company report that he expects floating-rate loans to become a more prevalent part of investors' asset allocations, "particularly given their diversification potential and the measure of protection they may help to provide in an environment of rising interest rates and higher inflation." Egerter adds that he sees REITs as being a large purchaser of maturing floating rate debt.

Investors are returning to floating rate debt because of the belief that lenders and special servicers got smarter in the past couple of years following the recession, Egerter says, allowing them to make better decisions on the basis of performing or non-performing properties. "It's easier now for lenders to take a harder stance on a loan modification, he says. "Regulators are putting a lot of pressure on lenders to clean up balance sheets, and the willingness of a lender to work with a borrower on a nonperforming asset may not be as strong as a couple of years ago. Today, lenders better understand the distress market."

It really comes down to whether or not the property can perform, says Egerter. If a property survived only because of its low floating rate, the only options available will be to either pump more cash into the asset or sell it. Lenders are now more than willing to liquidate these loans, he says.

This is true of the CMBS market. According to Chicago-based Morningstar, about $1.27 billion in delinquent CMBS loans were liquidated in June, the second highest monthly liquidation amount on record. Also, according to New York City-based Real Capital Analytics' mid-year data, full recoveries were achieved on one-third of defaulted acquisition and refinance loans through the first half of 2011, while another third achieved recovery rates of 60% or less. "Restructures and extensions contracted sharply in Q2 2011 as lenders increasingly preferred liquidations," according to the July report.

Deb Schiavo, managing director of debt advisory services with Cohen Financial, put it more bluntly: "If you've got a floating-rate loan in trouble today, you're not going to be able to refinance," she says. Schiavo agrees with Egerter that the special servicers have figured out their role, and with sufficient staff now in place are looking at completing a greater number of liquidations.

Her co-worker Carroll says that economic bubbles that keep bursting from weak fundamentals, such as the stock market drop in early August, won't help borrowers in the long run. "People are making bets that things are going to get better, and they won't until there's either real job growth or renewed discipline on capital-market pricing. The latter, by the way, is never going to happen," he says.

The one bright spot, Carroll says, is that distressed deal activity has picked up dramatically. "We're seeing cash flow, new capital and new management, which is good for the market," he says. So sellers may get a better price than would have been offered in the past two years, Egerter says. "In today's market, cap rates are attractive, you can buy off of projected NOI," he says. Borrowers should not fear taking out fresh floating-rate loans, he says, as long as there's a way to add value to the asset. "It's appropriate for loans such as construction where the asset is not yet stable," Egerter says. "With the shorter term floating rate, you can refinance the debt at some point without any issues relating to repayment fees, defeasance or yield issues that you would have on a fixed-rate transaction."

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