The Impact of Rising Interest Rates on Commercial Real Estate

Everybody has watched interest rates with great interest, particularly commercial real estate investors.

As policymakers seek to curb inflation by keeping interest rates propped up, CRE investors must pay even closer attention to the details of deals they’re considering. That’s because the interest rate on a loan results in higher or lower borrowing costs. In turn, those costs can chip away at an investor’s gains or can boost them.

How do interest rates affect commercial real estate?

Interest rates affect borrowing activity that backs CRE deals. Lower interest rates tend to fuel more lending activity, while higher interest rates tend to spur a lending cool-off.

Amid the current interest rate environment, with the Federal Reserve continuing to hike the benchmark interest rate, lending generally has tapered off. CRE loan rates normally move in tandem with the benchmark rate, which jumped from 0% to 0.25% in January 2022 to 4.25% to 4.5% in January 2023.

Coupled with interest rate hikes, recessionary fears and property valuations have caused weaker interest in CRE financing.

Indeed, the Mortgage Bankers Association predicts mortgage borrowing and lending for commercial real estate (including multifamily) will decline to $700 billion this year, down 5% from the estimated $740 billion in 2022.

“Tighter financial conditions tend to have a direct impact on commercial property prices by making it more expensive for investors to finance new deals or refinance existing loans, thereby lowering investment in the sector,” according to the International Monetary Fund. “They could also have an indirect impact on the sector by slowing economic activity, reducing demand for commercial property such as shops, restaurants, and industrial buildings.”

How do inflation and interest rates correlate with each other? 

When inflation goes up or down, interest rates tend to go in the same direction. Why? Because interest rates are the main tool used by the Fed to manage inflation, according to Investopedia.

So, if inflation is on the rise, the Fed typically boosts interest rates to ease inflation. On the other hand, when inflation is low, the Fed may cut interest rates to stimulate the economy, Investopedia explains.

In December 2022, the inflation rate stood at 6.5%, down from a peak of 9.1% just six months earlier.

How do interest rates affect cap rates?

When inflation and interest rates climb, capitalization (cap) rates usually follow suit.

However, cap rates might increase more slightly than interest rates do. Plus, factors aside from inflation and interest rates affect cap rates. These include the asset class, the condition of the economy where a property is located, forecasts for rent growth, and supply and demand for different property types.

Typically, two asset classes — multifamily and industrial — feature the lowest cap rates in CRE.

How to choose properties amid high inflation and interest rates

So, as inflation and interest rates remain high, what do real estate investors need to keep in mind when it comes to choosing projects?

First of all, higher inflation and interest rates mean investors should be even more meticulous when undertaking due diligence:

• Drill into the details of a property you’re considering, along with the area around the property. Is the property well-located? What is the outlook for growth in that area?
• Examine the local market. What are the prospects for population and job growth? Are properties trading for questionably high rates?
• Do the math. What is the likelihood that property values will go up during an inflationary period? What might happen with property values if the economy deteriorates?
• Consider putting off a purchase or sale. If you can wait, you might be better off delaying a deal. For instance, property prices generally go down in the wake of a recession, meaning your patience could result in scoring a post-recession deal.
• Hunt for undervalued assets. You may be able to acquire an asset with a relative low value that makes it an attractive acquisition target. This may include properties that need to be rehabbed.

How will the housing and multifamily markets be affected?

So, if interest rates and property values remain elevated, what will the impact be on the housing and multifamily markets?

As interest rates stay well above recent lows, some potential homebuyers remain on the sidelines. That bodes well for the multifamily market, with those would-be homebuyers pushing up demand for rental properties. In turn, this might result in more long-term renters, giving rental properties more stability.

Still, investors should be selective about which multifamily properties they purchase. Should you focus more on the suburbs than the urban core? What is the projected cap rate? And where can you find the best interest rate for a CRE loan?Bottom line: While interest rates shouldn’t be the only factor in driving a CRE investment decision, the cost of borrowing money certainly shouldn’t be overlooked.

Obtaining financing from balance-sheet lenders that have deep expertise in today’s challenging market environment is a great way to hedge your portfolio against rising interest rates. Contact the Broadmark Realty Capital team to learn more about our investment solutions.