By Todd McNeill
In 2015 and again December 2016, the Federal Reserve began to increase interest rates for the first time since 2006. There has recently been debate about what this will mean for the U.S. economy both as a whole, but specifically for those of us in the Commercial Real Estate sector, what it means for our industry. Rising interest rates does not mean a complete meltdown in the real estate market, however, leverage is one of the main drivers of any real estate deal, whether acquisition or new development.
In the short term, these higher rates will prompt a perception about future rate hikes that could drive borrowers to seek refinancing immediately, before rates rise again. Higher interest rates may constrain investment property sales, as an increased cost of capital acts as a barrier to entry for some borrowers that have to pay higher interest rates to access the leverage they need to appease their equity partners.
An increased interest rate also means that the “rental price of money” has gone up. Borrowers will be content with lower loan proceeds as debt service coverage constraints will limit leverage. A borrower may not feel comfortable keeping up with interest payments on a larger loan, forcing them to either put up more equity upfront or target lower-priced properties. Further, higher-risk loans (such as construction loans), and assets may become even harder to finance when interest rates surge. Finally, and most assuredly, higher capital costs will increase default risks for loans especially on floating rate structures.
Property valuations may also be impacted; when borrowers can rent money cheaply property values tend to increase. In theory, if rates continue to increase and then remain elevated, valuations must adjust downward to allow for the appropriate risk adjusted to returns on investment. Historically, property valuations tend to trail interest rate movement by six to nine months.
With higher interest rates, borrowers will feel the pinch as well. Knowing that higher interest rates erode both borrower cash flow after debt service and property valuations, we see lenders responding by tightening lending standards and underwriting scrutiny. When lenders and borrowers know that a higher interest rate will make it harder for borrowers to maintain debt coverage ratios and for property values to remain stable, both have reason to be more cautious and thoughtful before making a loan.
As with anything, there is a silver lining: with tightening lending standards and more scrutiny, increasing interest rates create more discipline in the market. This translates to a stronger CRE economy and less likelihood of CRE bubble or crash. When lenders become more selective, borrowers quickly adjust to the new reality by putting up more equity, accepting lower returns or reducing cost basis by lowering the price or figuring a way to build it cheaper.
Finally, interest rate hikes tend to follow the signal of a strengthening economy. “This action marks the end of an extraordinary seven-year period during which the federal funds rate was held near zero to support the recovery of the economy from the worst financial crisis and recession since the Great Depression,” Federal Reserve Chairwoman Janet Yellen said in her announcement of the rate hike. Indeed, the fact that the Fed has raised interest rates means that economists consider the economy to be in good shape, and a healthy economy is ultimately, a boon for healthy real estate market.
So as you can see rate hikes are not inherently good or bad for commercial real estate. However, when rates go up, borrowing costs follow so if your intention is to hold a property long term, now is the time to place long-term fixed-rate debt on your portfolio – you can count on that.