Every time the Federal Reserve (Fed) increases interest rates, individuals — and investors — pay more in interest. For example, interest rates by 0.25 percentage points equals $25 more in interest per $10,000 of debt. With many economists and financial experts anticipating at least six interest hikes this year —to a total of 1.5% higher rates, that adds to $150 more for every $10,000.
Higher market interest rates equal more expensive financing for those in real estate. The cost of doing business grows, mirroring the rising expense of borrowing more money. But what does that mean for the commercial real estate industry?
A Tricky Situation
The U.S. and global economies are experiencing significant inflation. It reached nearly 8% in February 2022 — a 40-year high — and the Fed is trying to curb it by raising rates. There’s a fine line, though, in these calculations. If the Fed raises interest rates too high, it risks nudging the economy into a recession.
The ongoing war and higher energy prices resulting from demand and a strong labor market (and no sign of demand capitulation to drive prices down) are contributing to inflation, too. And the European Central Bank (ECB) and Fed are coordinating to respond. For example, in March, the ECB announced plans to phase out its bond-buying program by or before the fall. It also plans at least one interest rate hike this year.
How Many Hikes to Go?
Experts disagree on the specific number of rate hikes the Fed will employ this year, but most agree on a range between three and six. Economist Ryan Severino said, “They’re going to try to be careful and consistent especially because we’re dealing with a new variable in the equation [the war in Ukraine] that we haven’t really dealt with in a long time.” His model suggests the market could bear increases within the 200 to 300 basis-point range but he said, “I don’t think [the Feds] will be able to raise in such a way that becomes too uncomfortable for the sector.”
After raising interest rates 25 basis points in March, however, the Fed indicated it planned an additional six increases — intending for rates to reach 1.9% by December. It raised benchmark borrowing rates for the second time in 2022 by half a percentage point in May.
It also said it was considering another two rate hikes in 2023. It did revise its projections for economic growth and inflation. Its projections included core inflation (not including energy or food costs) at 4.1% this year and growth slowing to 2.8%, a decrease from 4% in December 2021.
A recent investor survey conducted by one brokerage company found the investment community unlikely to pull back from acquisition plans unless there was another 100 basis-point hike from a low of 2% to 2.9-3% — or possibly as high as 3.25% — on the 10-year Treasury. Additionally:
- 70% of investors planned to make no changes for a 50 basis-point rate increase.
- 67% would not adjust plans for a 100 basis-point increase.
- 48% would not change for a 150 basis-point increase.
- 63% would change plans and buy less, however, with a 200 basis-point increase.
- 67% would purchase less real estate if faced with a 250 basis-point increase.
Fed Chairman Jerome Powell said, “In my view, the probability of a recession in the next 12 months is not particularly elevated. We do feel the economy is very strong and well positioned to handle tighter monetary policy.”
On a May 17, 2022, Powell indicated the Fed will continue increasing rates until inflation begins to fall, telling The Wall Street Journal he would back interest rate increases and saying, “If that involves moving past broadly understood levels of neutral, we won’t hesitate to do that. We will go until we feel we’re at a place where we can say financial conditions are in an appropriate place. We see inflation coming down.”
A Mixed Effect for CRE
Depending on which CRE economist you ask, the Fed’s planned rate hikes may or may not have a significant impact on the CRE industry’s health. The industry remains strong. Hotels are recovering as the travel industry continues to grow. The industrial sector is also booming, as demand — and rent — increases. Even the still-lagging office sector is seeing some improvement, especially within the midsize office markets, with companies looking at more budget-friendly options outside the big cities.
But rising rates could influence some to move cautiously. Companies might lower projections for future space needs, leading landlords to offer current tenants options to lock in longer leases at the current rates. After all, it’s generally easier to keep an existing tenant than to find a new one. Office finance could struggle with rising rates. According to one estimate, refinancing volume for office commercial mortgage-backed security (CMBS) could hit $10.3 billion in 2022.
There is, however, a silver lining: capital sources may be more willing to lend. Higher rates could attract capital in Q3 and Q4 2022. Ultimately, however, sources agree that each CRE sector will respond differently to rising rates.
Sharper interest rates could slow multifamily issuance — which had been surging recently with such a low-interest-rate environment — with higher borrowing costs significantly reducing demand for debt finances. Even with declining unemployment and rising income, incomes aren’t keeping pace with inflation. But according to the U.S. Census Bureau, homeownership rates increased to over 65% in Q4 2021, so it’s possible more people are hoping to buy homes, even in a hot market with limited inventory and high demand.
Many retailers have rethought growth plans in light of the rising interest rates and slowing economy. Inflation may also affect discretionary income, so many CRE experts recommend taking a cautious, conservative approach to retail investment this year.
However many more interest rate hikes we see this year, Powell said he still hopes the Fed can achieve its inflation goals without tanking the economy.
“You’d still have a strong labor market if unemployment were to move up a few ticks. I would say there are a number of plausible paths to have a soft as I said softish landing. Our job isn’t to handicap the odds, it’s to try to achieve that,” he said. “There could be some pain involved to restoring price stability,” he said, but he anticipates that the labor market will remain strong, with low unemployment and higher wages.
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.