While inflation has hit a 40-year high, interest rates remain relatively low. They’re nowhere near the 6.5% levels of the early 2000s or 1980’s record-smashing 13.36%. In fact, today’s rates are at pre-pandemic levels.
For the third consecutive time, the Fed raised interest rates by 75 basis points in September. The current target federal funds range is between 3.0% and 3.25%, which was last seen during the 2008 financial crisis, and it’s likely we’ll see more increases before the end of 2022 or into next year.
Financial experts generally agree that with interest rates still relatively low, CRE buyers and investors should make purchases now before the Fed moves rates even higher.
What Do Higher Interest Rates Mean?
While not at stratospheric levels, higher-interest rates do impact the CRE market. Higher interest rates increase borrowing costs, borrowing more expensive for CRE projects. These increases cause a snowball effect, with construction projects slowing along with existing property sales. It becomes more of a challenge to secure commercial property funding when businesses and investors face unfavorable loan terms.
Another challenge with higher interest rates? Higher vacancy rates and defaults. We’ve seen this happen before, with physical assets losing value and tenants unable to afford monthly payments defaulting on their leases. Then, landlords can struggle to find new tenants to fill their vacancies.
CRE investors and owners have options for minimizing the effect of rising interest rates.
- Refinance existing loans to lock in low-interest rates, which can also help lower monthly payments and make qualifying for any new loans easier.
- Increase current revenues, especially if you’re a business, to generate more money for investing in CRE.
- Work with an experienced CRE broker who will help you navigate the market and find properties aligned with your budget and requirements.
2022 Purchasing Power by the Numbers
Let’s look at a hypothetical use case. We’ve seen purchasing power increase since January 2022, thanks to still low interest rates, rising incomes, and access to credit. However, rising interest rates have affected purchase power.
On January 6, the interest rate was 3.22%, giving someone with a $3500 monthly payment over $807,000 in purchase power. By February 3, the interest rate had risen to 3.55%, and purchase power (based on a $3,500 monthly payment) dropped to nearly $775,000. Interest rates continued to creep up to 4.16% on March 17, 4.72% by April 7, and 5.11% on April 21, with purchase power dropping to just under $644,000 at the end of the month — a drop of nearly $163,000 in just over 3 months.
CRE Offers a Hedge Against Inflation
Inflation often affects CRE less than it does other asset classes, including equities and bonds. But higher interest rates can dampen CRE — as rates increase, business tenants may put plans to increase their space on hold. Yet low-interest rates drive inflation because they grow available cash assets, thus creating higher prices for products and services.
However, because rents increase with inflation and property values also appreciate, investing in CRE can offer a hedge against inflation. A caveat: higher interest rates lead to increased debt financing costs for CRE projects, so invest wisely.
Interest-rate Hikes and Multifamily Investors
Whether you’re considering purchasing a multifamily property or refinancing an apartment complex, seeking a fixed-rate loan now isn’t a bad idea. But keep in mind other factors beyond current interest rates, such as:
- The current financing structure. Variable-rate financing and interest rate hikes may affect short-term loans more than long-term loans. Watch the 10-year Treasury yield, which is used to help determine mortgage rates. Many economists also view the yield as a sign of investor sentiment about the economy. Falling yields can indicate lower inflation — and hint at a possible slowdown or recession. On the other hand, rising yields can reflect higher levels of expected inflation over the long term.
- Your local market. Evaluate property capitalization rates which typically increase when interest rates increase. Because real estate is generally local, analyzing the specifics of your market prior to purchasing or refinancing makes good financial sense.
- Supply and demand — and demographic shifts. Demand continues to significantly outpace supply in the housing market, especially affordable housing. Highly populated urban hubs aren’t attracting as many new residents as the mid-sized and smaller cities, which are seeing healthy population growth.
For all its fits and starts, the economy remains fairly robust; however, other outside factors, including new strains of the coronavirus, war in Ukraine, and ongoing supply chain issues could exacerbate inflation here and potentially lead to a recession.
Where does that leave CRE investors and owners? Carefully evaluating all factors when analyzing which CRE properties to invest in. While the market has remained solid, and many economists predict interest rates climbing to near 6% by the end of the year, putting pressure on cap rates. It’s possible, as we move into 2023 that buyers will want to acquire deals at a 7% or 8% cap rate even as sellers prefer cap rates at 6% or lower, resulting in sellers opting to hold onto their properties longer and buyers having fewer options from which to choose.
Are you a commercial real estate investor or looking for a specific property to meet your company’s needs? We invite you to talk to the professionals at CREA United: an organization of CRE professionals from 92 firms representing all disciplines within the CRE industry, from brokers to subcontractors, financial services to security systems, interior designers to architects, movers to IT, and more.