What do Higher Interest Rates Mean for CRE?
Throughout the last several years, the US market has enjoyed artificially low interest rates that have allowed the commercial real estate market to boom. As it has been cheaper to finance projects, many people have turned to real estate investment and have done well. However, in 2022, there has been inflation as high as 8.6%, which is the largest increase since 1981. In order to combat this skyrocketing inflation, the Federal Reserve Bank raised interest rates by a quarter of a percent on March 16, 2022 and plans to continue raising it over the coming year. What does this sudden rise in interest rates mean for real estate investors, and how can it be ameliorated?
Simply put, higher interest rates make debt more expensive and promote saving, which makes fundraising for projects difficult in both debt and equity. The increased cost of debt may also cause negative leverage (when the cost of debt begins to eat into cash flows and profits), as well as higher cap rates, which will raise the required return for projects. Investors will need to be compensated for the higher risk on their investment with lower prices. With the decrease in asset value, investors will look for increased rents in order to supplement cash flows and will most likely increase hold periods for their assets. Default rates among renters could increase, which will lead to higher vacancy rates, although as of right now, vacancies for CRE are at 4.5%, a significantly low number considering the interest rate.
In some ways, however, the increase in interest rates could have a positive effect on real estate investors. With the high cost of debt, many inexperienced investors will not have the ability to raise the capital needed to fund their projects. Due to this, competition will decrease, and experienced investors will have a window of time available for creative investing without the crowding caused by high-performing real estate markets. The hike in interest rates will allow for a more efficient allocation of resources across the real estate market over the next 12-18 months.
Overall, the commercial real estate market is doing well outside the office sector and is expected to grow over the next two years despite inflation and interest rates. Even within the office sector, the market is expected to improve due to the general return to in-office work post-COVID-19. The high interest rates are also decreasing demand for mortgages, allowing the multifamily sector to grow considerably. Rents for multifamily are constantly rising, making them a good hedge against inflation. In the industrial sector, logistics (warehouse, distribution, fulfillment centers) continues to be a major market driver. The retail sector may not be as good an investment now, however, as the higher interest rates and wildly growing inflation have many consumers cutting back spending on non-essentials.
With much higher than historical interest rates on the horizon, the commercial real estate market has the potential to deteriorate significantly. However, as of now, CRE markets are as strong as ever and still have growth to come.
Submitted by KJ Worley