Interest Rate Swap
by Dulan Perera
Director of Growth
Updated 11 May 2026
Contents
Key Takeaways What is an interest rate swap? Why do commercial real estate borrowers use interest rate swaps? How do interest rate swaps work? What are the main types of interest rate swaps? How are interest rate swaps priced and valued? What are the risks of interest rate swaps? How are interest rate swaps accounted for?Key Takeaways
- An interest rate swap exchanges fixed and floating interest payment streams between two parties, without exchanging the underlying principal amount.
- Commercial real estate borrowers commonly use fixed-for-floating swaps to convert variable-rate debt into predictable fixed payments, protecting against rate increases.
- Since the LIBOR transition, most USD interest rate swaps reference SOFR (Secured Overnight Financing Rate) as the floating rate benchmark (CFA Institute, 2026).
- Key risks include counterparty credit risk, basis risk if the swap and loan reference different rate indices, and early termination costs if conditions change.
- Swap pricing depends on market rate expectations, the creditworthiness of both parties, and the present value of future payment differences.
What is an interest rate swap?
An interest rate swap is a derivative contract where two parties agree to exchange interest payment streams on a specified notional principal for a set period. Only the net difference in interest payments changes hands at each settlement date. The principal amount is never exchanged.
In commercial real estate, interest rate swaps are most commonly used to convert floating-rate loan payments into fixed-rate payments. A property owner with a variable-rate mortgage can enter a swap to lock in predictable debt service costs, which stabilises cash flow projections and protects the property's debt service coverage ratio (DSCR).
Since the global transition away from LIBOR, most USD-denominated swaps now reference SOFR (Secured Overnight Financing Rate) as the floating rate benchmark. GBP swaps typically reference SONIA (Sterling Overnight Index Average).
Why do commercial real estate borrowers use interest rate swaps?
Commercial real estate borrowers use interest rate swaps to manage the cost and predictability of their debt. Swaps are particularly valuable when borrowers secure floating-rate loans at attractive spreads but want the payment certainty of a fixed rate.
Hedge against rate increases. A borrower with a SOFR-based floating-rate loan can enter a swap to pay a fixed rate instead, protecting cash flow if rates rise.
Stabilise debt service coverage. Fixed payments make it easier to maintain consistent DSCR, which satisfies lender covenants and supports property valuations.
Avoid refinancing costs. Rather than refinancing an existing floating-rate loan into a fixed-rate product (with associated fees and break costs), a swap achieves the same economic outcome without changing the underlying loan.
Optimise portfolio-level risk. Property investors with multiple assets can use swaps strategically to balance fixed and floating exposure across their portfolio based on market outlook.
How do interest rate swaps work?
In a standard fixed-for-floating interest rate swap, two parties agree to exchange interest payments on a notional principal amount for a set period. One party pays a fixed rate and receives a floating rate. The other pays a floating rate and receives a fixed rate. At each settlement date, only the net difference between the two payments is exchanged.
Worked example
A commercial property owner has a $10 million floating-rate loan at SOFR + 2.00%. To hedge against rising rates, they enter a 5-year interest rate swap with a bank.
| Component | Details |
|---|---|
| Notional principal | $10,000,000 |
| Loan rate | SOFR + 2.00% (floating) |
| Swap fixed rate | 4.50% (paid by borrower) |
| Swap floating rate | SOFR (received by borrower) |
| Swap term | 5 years |
Net result for the borrower: The SOFR components cancel out. The borrower effectively pays a fixed rate of 4.50% + 2.00% spread = 6.50% regardless of where SOFR moves during the 5-year term.
If SOFR rises to 5.00%, the borrower still pays an effective 6.50% instead of 7.00% (SOFR 5.00% + 2.00% spread). The swap saves the borrower 0.50% annually, or $50,000 per year on a $10 million loan.
What are the main types of interest rate swaps?
Interest rate swaps come in several structures. The right choice depends on the borrower's existing debt, risk tolerance, and market view.
| Swap type | How it works | Common CRE use case |
|---|---|---|
| Fixed-for-floating (plain vanilla) | One party pays a fixed rate, receives a floating rate | Borrower with floating-rate loan locks in fixed payment |
| Floating-for-fixed (reverse swap) | One party pays a floating rate, receives a fixed rate | Borrower with fixed-rate debt seeking to benefit from falling rate |
| Basis swap | Exchange of two different floating rate indices | Managing basis risk between loan index and hedging index |
| Amortising swap | Notional principal decreases over the swap term | Matching a swap to a loan with scheduled principal repayment |
| Forward-starting swap | Swap begins at a future date | Locking in rates for a construction loan that converts to permanent financing |
The plain vanilla fixed-for-floating swap accounts for the majority of interest rate swaps in commercial real estate. Most property borrowers enter this structure to convert variable-rate construction or bridge loans into predictable fixed payments.
How are interest rate swaps priced and valued?
The pricing of interest rate swaps depends on several factors:
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Market expectations for interest rates over the swap's duration
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Creditworthiness of the parties involved (higher-rated entities receive better pricing)
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Present value calculations of future interest payment streams
The value of a swap fluctuates as market interest rates change, which can impact financial statements and risk management strategies.
What are the risks of interest rate swaps?
Interest rate swaps reduce rate risk but introduce other risks that borrowers must evaluate before entering a contract. The three primary risks are counterparty default, adverse rate movements, and termination costs.
Counterparty credit risk: If the other party to the swap defaults, the borrower loses the hedge and may face replacement costs at less favourable terms. Working with highly rated counterparties (major banks) reduces but does not eliminate this risk.
Interest rate risk (opportunity cost): If floating rates fall below the fixed swap rate, the borrower pays more than they would have without the swap. The hedge provides certainty, but that certainty has a cost when rates move in the borrower's favour.
Early termination costs: Exiting a swap before maturity requires a mark-to-market settlement. If rates have moved against the borrower's position, the termination payment can be substantial, sometimes exceeding several percentage points of the notional amount.
Basis risk: If the swap references a different floating rate index than the underlying loan, the hedge may not perfectly offset rate movements. This became more relevant during the LIBOR-to-SOFR transition.
Complexity and documentation: Swaps require ISDA Master Agreements and detailed schedules. Legal and advisory fees add to the total cost, particularly for smaller transactions.
How are interest rate swaps accounted for?
The accounting and tax treatment of interest rate swaps can be complex:
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Swaps may qualify for hedge accounting treatment if properly documented, which can help match the timing of income statement impacts.
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Without hedge accounting, swaps are typically marked-to-market with gains/losses flowing through income.
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Tax implications can vary depending on the jurisdiction and specific circumstances of the swap.
In conclusion, interest rate swaps are powerful financial tools that can help commercial real estate entities manage interest rate risk and optimize their debt structures. However, they require careful consideration of pricing, risks, and accounting implications to be used effectively.
