Commercial real estate (CRE) is deeply influenced by the level and trajectory of interest rates, and the current trend of rising rates is reshaping the landscape. Understanding this impact is crucial for investors, developers, and business owners alike. Importantly, CRE is an umbrella term that refers to various types of real estate such as office, multi-family, student housing, data centers and more, each of which may be impacted differently by interest rate movements. In this blog we will discuss ways in which higher interest rates impact the CRE space as a whole.
- Higher Borrowing Costs
One of the most immediate effects of rising interest rates is the increased cost of borrowing. Commercial real estate projects often rely heavily on debt financing. Thus, higher interest rates increase the cost of debt service and erode profit margins. This can potentially deter new developments and acquisitions, as the financial viability of projects may be compromised. - Decreased Property Values
As borrowing costs rise, potential buyers may be less willing to pay premium prices for properties. Higher interest rates can lead to lower property valuations as the increased cost of financing reduces buyers’ abilities to take on larger amounts of debt. Investors might seek higher rental yields to justify the increased expense, putting downward pressure on property prices. - Cap Rate Adjustments
Capitalization rates (cap rates) are used as a measure to evaluate the return on investment in real estate. Cap rates are found by taking the net operating income of the property and dviding it by the property value. These rates tend to move in tandem with interest rates. As interest rates rise, cap rates generally increase. Real estate investors typically demand a higher return on their investments to compensate for the increase in capital outlays. To justify the perceived risk associated with achieving these higher returns will generally cause investors to require higher cap rates (i.e., lower property valuations). Accordingly, cap rates are a key ratio for assessing potential future returns on real estate investment. - Shift in Investment Strategies
Rising interest rates can lead investors to reconsider their strategies. There may be a shift from highly leveraged investments to more equity-based financing or even a move towards sub-sectors within real estate that are perceived as less sensitive to interest rate changes, such as industrial properties or certain types of residential real estate. Many real estate investments are illiquid and privately traded, making it harder to re-allocate if the investment falls out of favor and does not coincide with the initial investment thesis. Investors should be wary of this when deciding how and where they invest in real estate. - Increased Demand for Fixed-Rate Financing
To mitigate the risk associated with fluctuating interest rates, investors may increasingly look to lock in rates using fixed-rate financing. This preference for stability can influence the types of financial products offered by lenders and the overall structure of real estate transactions. However, it is important to note that fixed rate financing does not necessarily eliminate interest rate risk. Rather, it can simply defer it into the future. When fixed-rate debt matures, owners must either pay off the debt or refinance at prevailing rates, and there is no guarantee that rates will be lower in the future. - Operational Cost Implications
Higher interest rates can also impact operational costs for businesses leasing commercial spaces. Rising rates can lead to inflationary pressures that impact the cost of utilities, insurance, and other operational costs for businesses. . Lessees may also face increased rental costs as landlords seek to pass on higher financing expenses through lease agreements. Higher rental and operational costs may create a more challenging operating environment that leads to increased vacancy rates and longer turnover times, ultimately damaging the profitability of an investment. - Market Volatility and Uncertainty
Rising interest rates introduces a source of uncertainty and volatility into the real estate market. Investors and developers may understandably adopt a more cautious approach, leading to fewer transactions and projects, and ultimately, slower growth in the sector. Market participants must stay informed and adaptable to navigate these changes effectively.
Adapting to the New Normal
In an environment of high and/or rising interest rates, stakeholders in the commercial real estate market should consider several strategies:
- Refinancing Existing Debt: Locking in lower rates before rates increase further can be beneficial.
- Diversifying Portfolios: Investing in a mix of asset classes can reduce exposure to interest rate fluctuations.
- Emphasizing Cash Flow: Prioritizing properties with strong, stable cash flows can help offset the risk of higher financing costs.
- Leveraging Technology: Utilizing advanced analytics and market data can enhance decision-making and identify opportunities in a shifting landscape.
Conclusion
Periods of rising interest rates present both challenges and opportunities for the commercial real estate sector. By understanding the implications of rising rates, investors can adjust their strategies, focus on cash flow management, and explore new opportunities that align with their financial goals.
It is worth noting that, while all the foregoing is true regarding how rising rates can affect commercial real estate, recent economic developments may be bringing an end to this current rising rate environment. The Federal Reserve has indicated that it may be pursuing a change in rate policy in the near future, which could reduce or even reverse the effects of higher rates discussed above. Staying informed and flexible is key to navigating the evolving landscape of commercial real estate in a volatile interest rate environment. Consult an experienced advisor for more information.
This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy,” dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment, or other professional advice. The views expressed are those of the author(s) as of the date of publication of this article and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future.
