While the commercial real estate market has seen steady gains over the last four years, the recent rise in interest rates could drive such gains to a halt. The previously low commercial mortgage interest rates had consistently fed a recovering commercial real estate market. Lower commercial mortgage interest rates allowed buyers to pay more for properties, even as rents and occupancies remained low. Analysts believe that the rise in commercial mortgage interest rates will take away recent gains in property values and rent growth.
Rising interest rates will most significantly impact those seeking to finance 75 percent or more of their purchase. One of the hardest hit financial vehicles in the current market environment has been commercial mortgage backed securities. Commercial mortgage backed securities, whose borrowers’ rates have seen nearly an entire percentage point increase, represent the majority debt source in the commercial mortgage space. Buyers seeking commercial mortgage backed securities financing saw their interest rates increase by about 100 basis points. Such sharp increases significantly impact price, with some buyers and sellers finding themselves in renegotiations due to the financing market.
While this may seem particularly dire, one must remember that even as rates maintain a steady climb, these commercial mortgage interest rates are still historically low. As property owners begin to put thoughts of selling or refinancing on hold, there is a keen opportunity at hand for some owners who are currently sellers. Major markets tied to the energy and technology sector have consistently seen rises in rents and occupancies. Further, there is a strong opportunity in multi-family which has seen strong gains across all markets. Such owners will find consistent interest from buyers due to continued appreciation upside potential.
Another major opportunity for current sellers comes from cash buyers who finance 50 percent or less of their purchases. Such buyers are far less concerned with rising interest rates. While interest rates will not directly impact their deals, rising interest rates can impact their valuation models. Appreciation and income compose a property’s total return, and ever since the 10 year yield hovered around 1.5 percent late last year, many buyers have been building yields of 3 percent to 3.25 percent into their valuation assumptions when pricing potential investments.
Investors’ main goal should be to guard against value erosion amid interest rate hikes. As a property’s value drops, rents must rise to maintain expected returns. Rents would have to grow by 4 percent to 5 percent, for example, to counterbalance a 25 basis point lift in capitalization rates, which rise as values fall. A 5 percent rent increase is substantial and will not be viable for most owners.
The Fed interest rate policy had created significant appreciation scenarios for commercial property owners. Some institutional owners saw annual appreciation rise as high as 9 percent, which was nearly double the income contribution to total returns. As real estate has historically been an income oriented investment, savvy investors should set realistic appreciation expectations. In order to make a sound investment, investors should remember that 80 to 90 percent of their return will be derived from the income component.