Though inflation and rising interest rates might raise the alarm, they are a natural part of the economic cycle, including in real estate. Historically, commercial real estate has been known as a great hedge against inflation during uncertain times and as a way for investors to diminish their risk during this point of the cycle. By studying economic periods of the past, investors can better inform themselves of how high inflationary periods, coupled with high interest rates, have previously affected investments. What happened decades ago may lend some insight into the markets of today.
As for interest rates, rising costs of borrowing are also making their impact known. By the end of 2022, the 10-year Treasury rate stood at 1.63%, and yield on 10-year properties for investors went from 4.25% to 3.71%. While borrowing costs for investors are not exactly equal to the Treasury note, they do tend to follow the same trends. This is because the market interest rate for commercial real estate financing is typically established with the 10-year Treasury as a starting point.
Like other tangible assets, commercial properties tend to appreciate in value proportionate to increasing rates, though this is not a guarantee. Several variables and compounding effects come into play when seeing how inflation might impact a property.
First, the type matters. Inflation caused by strong economic growth is a good thing, especially for commercial real estate. Investors often have the opportunity to potentially benefit from locking in historically low interest rates before the Fed increases them. This means the property cost remains the same, but its value appreciates. For example, in 2022, the Fed raised rates to combat the current economic environment. Any debt incurred after those dates features the new, higher rates, as opposed to debt incurred before this time period.
Rising costs of material and labor often prove beneficial too, especially with less competition for other properties coming to the market. An increase in costs means developers are more likely to halt their current projects, leading to less supply and more demand for existing properties. This leads into a “double-hedge” effect, where high inflation and interest rates both contribute to how well commercial real estate weathers the current market.
It comes as no surprise that as interest rates increase, as they have in the past year, investors might be impacted by these higher borrowing costs. Rising rates tend to reduce the cash flow to the investor from a property. As an example, imagine an investor purchases a commercial property for $10 million and finances the deal at a rate of 3.75%. The lender agrees to lend at 65% loan-to-value, which means the investor can borrow up to 65% of the appraised value of an asset. This equates to $6.5 million, with the investor contributing the remaining $3.5 million.
In this example, the loan term is 10 years, which is common in the commercial real estate industry. The interest rate payment calculation is as follows:
This means the payment comes out to be approximately $20,312 per month. Increasing the rate by 2%, or from 3.75% to 5.75%, results in an increase of almost $11,000 to each monthly payment, meaning the investor is left with less money after paying back their debt and operating expenses.
The above example demonstrates how the rising rates can lead to a slowdown in both business and investor demand, especially for development projects. It can also lead to higher vacancy rates in certain assets as tenants default on their leases, or property owners struggle to refinance their loans.
When it comes to inflation, certain assets also tend to perform better or worse depending on the circumstances. This is why it is important to consider the type of asset. Consider, for example, multifamily properties, offices, and industrial warehouses.
Affordable housing supply is currently low, and demand is outpacing supply. More people have moved to the center of the country, as well, and are seeking workforce housing, which may show that moving investments to the suburbs will be more beneficial than staying with properties in the cities.
Meanwhile, other properties, such as offices, can benefit from these higher borrowing costs by focusing on incorporating key amenities and technology to encourage workers back into their properties. Investors would also benefit from considering operating expenses. In some cases, these costs can be passed on to the tenants through the lease structure, which can help the investor, but may hurt the tenant.
When it comes to industrial warehouses, rising interest rates often affect the tenants, but not necessarily the investors. Fewer warehouses may be built as a result of the increasing cost of materials and labor, but that leads to existing properties seeing an increase in demand. Long lead times and multi-year contracts may provide many investors and their tenants insulation from sharp fluctuations in the market, too.
Savvy investors will also know how to take advantage of rising rates. Generally, as interest rates climb, property values tend to decrease, which means it becomes much easier to purchase and finance an asset for those investors looking to break into a certain commercial sector. In some extreme cases, assets will fall in value to the point they become a better deal for the investor even though the expected cash flow is lower than before rates increased.
Higher interest rates and inflation can present opportunities, but they also come with a risk. As rates continue to climb, it becomes even more important for investors to guard against any negative impacts associated with either high inflation or high borrowing costs. Part of this includes taking the extra time to complete due diligence on an investing partner, such as a REIT or a private equity firm. Investors need to understand how the sponsor is responding to the changing economic environment.
The goal of performing due diligence, especially in today’s market conditions, is to understand how the sponsor may take advantage of any opportunities present, while still mitigating the risks. Investors may benefit from private equity firms that are both patient and disciplined in their investments, as they are more likely to be in a better position to succeed in the ever-changing environment.
As inflation and increasing interest rates slow down the current economy, investors may benefit from reviewing their assets and any potential acquisitions and seeing how they are impacted. Uncertainty and a drop in demand for labor and construction caused by these factors can lead to great opportunities, but not without some risk. Looking forward, the Fed is likely to stress test lenders’ appetites for funding commercial real estate endeavors, too. So long as investors complete their due diligence, they may be able to weather the various market shifts of the real estate cycle, leading to better returns later down the line.
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