How Rising Interest Rates Affect Commercial Real Estate Refinancing

Higher interest rates cut refinancing proceeds in two ways. They raise the payment on each borrowed dollar, which shrinks the loan that a coverage test allows. They can also lift capitalization rates, which lowers the value a lender accepts even when the property income has not changed. The equity a borrower must bring to closing depends on which loan-sizing test produces the smallest loan.

Rate increases hit the payment and the collateral value at once

A refinancing is sized against two things at the same moment: the payment the new loan carries and the value the lender assigns to the property. Higher rates press on both.

On an interest-only loan, annual interest equals principal multiplied by the rate. Hold the principal fixed and a higher rate raises the payment. A lender with a minimum debt service coverage ratio then solves backward, so the same income supports less principal. Floating-rate loans carry the cost of higher rates in current repayment during the term, which means the pressure shows up before maturity.

The value side runs through the cap rate. A cap rate is one year of net operating income divided by price, so value equals income divided by the cap rate. Rising rates can lift cap rates and reduce property values even when rents and expenses stay put. Higher cap rates can also reduce transaction volume.

Lenders react to both. Banks refinancing commercial loans may require strong income growth, and higher cap rates can make them assess appraised values and their own risk appetite more conservatively.

A property can pass the payment test and fail the value test in the same file.

Why the lowest of three loan-sizing ceilings sets the proceeds

Proceeds equal the lowest loan ceiling among all tests the lender applies, and a rate move can change which test sets that ceiling.

Debt service coverage ratio is underwritten income divided by annual debt service. Dividing income by the minimum ratio sets the maximum annual debt service, which limits interest-only loan principal to that amount divided by the interest rate. An amortizing loan needs a payment factor that includes scheduled principal, which lowers the ceiling at the same rate.

Loan-to-value multiplies the accepted value by the permitted percentage. Because accepted value is income divided by the cap rate, this ceiling moves with the cap rate and never touches the interest rate directly. Debt yield is underwritten income divided by principal, so a minimum debt yield caps principal at income divided by that minimum. That ceiling ignores both the interest rate and the cap rate.

Minimum ratios and maximum percentages differ by lender and by property type, so none of these thresholds is a market standard.

The cash a borrower must bring equals the payoff plus closing costs minus the replacement proceeds. Some borrowers with maturing debt have not secured refinancing because lending standards are tight, valuations are lower and rates sit above the levels that prevailed at origination.

A stress that moves only the interest rate changes the coverage ceiling and leaves the debt yield ceiling where it was.

Worked example: a hypothetical $12,000,000 office loan at 5% versus 7.5%

This illustration uses one hypothetical office property. Underwritten net operating income is $1,200,000, the maturing interest-only loan is $12,000,000, and closing costs are $200,000 paid in cash. The replacement lender applies a maximum loan-to-value of 65%, a minimum coverage ratio of 1.25x and a minimum debt yield of 10%. These thresholds are illustrative. Both cases use the same income and payoff, and the same costs over a one-year measurement period.

The base case uses a 5% interest rate and a 6% cap rate. The stressed case uses a 7.5% interest rate and a 7.5% cap rate. Income stays at $1,200,000 in both.

Base case ceilings: value equals $1,200,000 divided by 6%, or $20,000,000. The loan-to-value ceiling equals $20,000,000 multiplied by 65%, or $13,000,000. Maximum debt service equals $1,200,000 divided by 1.25, or $960,000, and $960,000 divided by 5% gives a coverage ceiling of $19,200,000. The debt yield ceiling equals $1,200,000 divided by 10%, or $12,000,000.

The smallest base ceiling is $12,000,000, so debt yield sets the proceeds and the new loan just covers the balance. Payoff plus costs equals $12,000,000 plus $200,000, or $12,200,000. The equity required is $12,200,000 minus $12,000,000, or $200,000.

Stressed ceilings: value equals $1,200,000 divided by 7.5%, or $16,000,000. The loan-to-value ceiling equals $16,000,000 multiplied by 65%, or $10,400,000. Maximum debt service is still $960,000, and $960,000 divided by 7.5% gives a coverage ceiling of $12,800,000. The debt yield ceiling is still $12,000,000.

The smallest stressed ceiling is $10,400,000, so loan-to-value now controls. The payoff plus costs is still $12,200,000, and the equity required is $12,200,000 minus $10,400,000, or $1,800,000. The proceeds fall short of the maturing balance by $12,000,000 minus $10,400,000, or $1,600,000, and the $200,000 of costs brings the total to $1,800,000. Against the base case, the equity requirement rises by $1,800,000 minus $200,000, or $1,600,000.

A payment-only view gives a different answer. Interest on the full balance equals $12,000,000 multiplied by 5%, or $600,000, in the base case and $12,000,000 multiplied by 7.5%, or $900,000, in the stressed case. The stressed payment sits $60,000 below the $960,000 coverage allowance.

On coverage alone, the stressed property carries the whole balance with room to spare. The collateral test says it cannot, and the debt yield test did not move at all because it ignores both rates. Higher borrowing costs and lower collateral value are separate effects, and here the second one binds.

“The differential between in-place interest rates on debt and market interest rates upon maturity has the potential to create an equity shortfall.”

Fixed-rate maturities and floating-rate extensions feel higher rates at different moments

A fixed coupon holds the payment steady until maturity, so the repricing arrives all at once on the refinancing date. Maturing fixed-rate office loans are a refinance risk for that reason: higher repricing can raise borrower payments, and the new loan may require additional equity.

The size of the gap between the in-place rate and the market rate at maturity is what can produce the equity shortfall. A loan that has paid on time for its whole term says little about whether it can be replaced at the same size.

Floating-rate multifamily borrowers face the problem earlier. Extending a maturing loan may require resetting an interest rate hedge at a costly premium, and rising rates may put downward pressure on refinancing proceeds and call for new capital.

Floating balances also raise repayment costs as rates rise, so coverage can weaken well before any refinancing is attempted.

The same rate move runs a different clock on each structure.

Lender appetite and the size of the maturity pile shape the odds of getting proceeds

Capacity on paper and willingness to lend are separate questions. When bank lending volumes decrease and terms tighten, with requirements such as additional equity injected into the asset, commercial real estate carries higher than normal refinancing and default risk.

Maturing balances are large. One forecast puts loan maturities at $1.5 trillion over a two-year window, and argues that higher borrowing costs and cap rates make extensions harder to justify. Another estimate counts more than $570 billion of commercial mortgages due within a single year.

Some credit investors argue that bank retrenchment has opened financing gaps, with many maturing loans facing higher rates and lower proceeds. Others frame the problem as $1.7 trillion of maturities meeting a $150 billion annual funding gap, and expect properties that barely produce cash flow at current rates to fail the tests for new loans. These figures come from different periods and populations and are not additive.

Owners who borrowed when rates were low face maturities in a higher-rate market on properties that have lost value, which creates a pressing need to sell or refinance.

None of these figures describes any one loan, but they set the backdrop against which each loan is sized.

“Borrowers who took out loans when interest rates were low in the pandemic years are still facing maturities in a higher-rate environment on properties that have lost value. These owners have a pressing need to either sell or refinance.”

An extension buys time and leaves the sizing gap open

An extension moves the repayment date. It does not change the arithmetic of the loan-sizing tests unless income, value or rates change during the added period.

A timing gap concerns when cash becomes available. A sizing gap exists when the principal due exceeds what the property can support under the assumed terms. Extensions can address the first and leave the second untouched.

The income needed at the later date can be stated directly. A stricter required coverage ratio raises the income needed to support the same interest-only principal and rate. A loan-to-value test can leave a sizing gap when required income exceeds the property’s income. Under a debt yield test, it equals principal multiplied by the minimum debt yield. Each formula names the operating result the extension period has to deliver.

Hedge resets add cash cost to the extension itself for floating-rate borrowers.

A plan that depends on a lower future refinancing rate is conditional on that rate.

Refinancing mistakes that hide the source of the equity gap

Sizing replacement debt on the existing coupon understates the payment whenever the market rate is higher. A fixed-rate loan that stays current through maturity shows performance under the old contract only. The replacement payment is set by the new terms, and the gap between the two rates is what can create the equity shortfall.

Reading flat income as flat value overlooks the cap rate in the denominator. In the example, $1,200,000 of income supports $20,000,000 of value at a 6% cap rate and $16,000,000 at 7.5%. Nothing about the building changed, yet the collateral fell by $4,000,000.

Treating the coverage ceiling as the loan amount ignores the other two tests. In the stressed case, coverage supports $12,800,000 while loan-to-value allows $10,400,000, and only the lower figure funds. The correct comparison lists every ceiling and takes the lowest before computing the cash gap.

Applying a rate shock to the debt yield test shows no effect, because that ratio is income divided by principal. A stress grid that varies only the interest rate can therefore look benign on one test while the cap rate moves another. Mixing projected income in one test with current income in another adds an operating assumption to what looks like a financing comparison.

Recording an extension as a funded solution omits the hedge reset premium that floating-rate borrowers may face and leaves the later principal gap unexplained. More time and more debt capacity are different outputs.

Checklist questions for a rate-driven refinancing review

Which income figure feeds each sizing test? Differences in proceeds can come from the terms or from mismatched income definitions.

Does the coverage calculation use the proposed payment structure? Scheduled principal belongs in debt service when the new loan amortizes.

Which ceiling controls the proceeds? The lowest applicable ceiling sets the modeled loan even when another test shows plenty of capacity.

What cap rate produces the value used for loan-to-value? That input explains how steady operations coexist with weaker collateral support.

How far apart are the in-place rate and the rate available at maturity? That differential is what can turn a performing loan into an equity requirement.

Does a floating-rate extension require a hedge reset? A reset premium raises the cash needed just to obtain more time.

What must change between the extension date and final repayment? A stated income or rate assumption makes the repayment path measurable.

How willing is the lender to fund the calculated amount? Calculated capacity and appetite diverge when lending volumes fall and terms tighten.

Do several holdings share one local market? Falling valuations in that market can make refinancing difficult across the whole portfolio at once.