The Commercial Real Estate market is complex, but among the most important factors are interest rates. Due to Federal Funds Rate hikes of 500 basis points over the past year, commercial real estate loans have suddenly become expensive after being cheap for a decade. This paper investigates how interest rates influence the CRE market by examining their importance to CRE and comparing rising/high interest rate environments to decreasing/low interest rate environments.
CRE Interest Rate Basics
In a typical CRE deal, a developer builds a new property and then sells it, or an existing property is sold. In both cases, interest rates play a major role. Coleman Team is a Partner at Front Street Capital, a development firm with 40 years of experience. Team stresses the importance of interest rates, saying that “the single largest factor of our business from an investment standpoint is our ability to borrow money. So, interest rates have a major impact.”
As a developer, Team thinks about interest rates when applying for a construction loan, the primary channel that a developer uses to gain access to capital. Team says that the interest rate environment “really affects the capital stack on both sides of the table,” meaning the amount of equity of the lender on one side of the table and the borrower on the other. Whether a lender is applying for a construction loan or a property-buyer pays interest on an existing term loan, interest rates are significant throughout the lifespan of a CRE deal.
High Interest Rate Environments
Over the past year, the Fed has raised interest rates many times to address inflation, substantially affecting CRE. Michael Holshouser, an SVP at Pinnacle Financial Partners, is a Financial Advisor-Area Manager. “[Rising interest rates cause developers’] interest line item on their budget to go up, which then runs up the total cost of the project,” Holshouser explains. When asked about how rising interest rates has affected Front Street Capital’s deal flow, Team illustrated that “it definitely has. It has become very cost-prohibitive to do these deals right now because of how expensive money is.”
Along with causing the cost of credit to increase, rising interest rates hurt the spread between cap rates and interest rates. Having a healthy spread between interest rates and cap rates is vital to the profits earned from selling a CRE property. Holshouser explains this dynamic. “In a 3-4% interest rate environment that 6% cap supports a lot more leverage than a 7-8% interest rate environment. So, that developer has to be willing to put in more equity up front on a deal when the interest rate environment is higher.” Increasing equity increases both the risk the developer must take and decreases the rate of return the developer will earn at sale.
Not only are loans more expensive and profits lower in a high interest rate environment, but demand and property values often decrease. The two phenomena are linked. As interest rates increase, investors tighten spending, driving down demand. This decrease in demand causes property values to decrease. Specifically, in CRE deals with a rent-paying tenant, property values will also likely decrease because cap rates likely increase. Team does point out that “[cap rates and interest rates] are not really in lockstep, although they do have a direct impact on each other…Cap rates lag interest rates in how they rise or fall.” A high interest rate environment causes loans to be more expensive, demand to decrease, and profits to decrease.
Low Interest Rate Environments
The historically low interest rate environment of the past 10 years benefited the CRE market. During this period, loans were more affordable, demand increased, property values surged, and refinancing was relatively easy.
A major benefit of low rates is increased profits. Holshouser reiterates that “the interest rate environment dictates how much leverage the borrower can get on a particular project.” When rates drop, borrowers can take out a larger loan, increasing their leverage and setting the stage for higher rates of return. At the same total dollar amount of profit, a borrower with higher leverage will have a greater levered rate of return than a borrower with less leverage. Rate of return, often measured via Internal Rate of Return (IRR) in CRE deals, is arguably more important than the total dollar profit earned because of underwriting standards. Banks and investors have underwriting standards to approve a loan, specifying a certain levered IRR threshold.
It is worth noting that low or decreasing interest rates are extremely helpful to the bottom line of a CRE deal, but both Team and Holshouser agree that rate stability is equally or more important than lower rates. Team argues that they are equally important, saying “consistent and somewhat lower interest rates would be my ideal scenario,” while Holshouser stresses consistency over rate level. “I would say, not necessarily picking a number to tie to an interest rate, but saying a consistent and predictable interest rate would be more ideal,” says Holshouser.
However, interest rates are not the only force affecting the current CRE market. Team says that “we’re really in kind of a double whammy right now, where monetary policy is limiting banks’ ability to be flexible in lending money and also the interest rates are significantly higher.” Team is referencing recent changes in monetary policy that require banks to have more liquidity, decreasing their ability to lend.
Put simply, interest rates remain an extremely important factor in CRE. The vast majority of CRE deals require loans, and loans have interest rates. Demand and property values can also be influenced by the interest rate environment. Low and stable interest rates are ideal, while unstable and high rates create headaches and volatility for the commercial real estate market. For more in-depth insights beyond this paper, seek guidance from a brokerage or bank.
This blog post was written by one of our dedicated interns as a part of our 2023 Summer Intern Program, where they delved into the world of commercial real estate. We’re thrilled to have played a role in their education and experience.
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