As of late last month, the Federal Reserve interest rate rests at 4.75% to 5.00%. This is the ninth time the Fed has raised rates since March 2022. Interest rates haven’t been this high since May 2006. The question is, how does this impact the commercial real estate industry? Investors are another factor to consider. When compared with cap rates, how do rising interest rates impact real estate investors’ ability to apply leverage to commercial real estate? Our team at Willowbrook Valuation has the answers you need.

High Interest Rates and the Commercial Real Estate Industry

There’s no doubt that a rising rate climate puts pressure on the commercial real estate market. Investors depend on leverage to increase their return on investment. When borrowing costs are high, leverage is equally costly. This lessens the chance for higher returns and ultimately leads to a decline in demand for commercial real estate projects. As development slows, property values decrease as well. This scenario comes with a silver lining, however. Investors who are willing to deal with these complications benefit from less competition.

Rising Interest Rates vs. Cap Rates

Cap rates, which gauge a property’s overall value, also affect the opportunity to apply leverage in commercial real estate. In most cases, low cap rates signify a lower return on investment, whereas high rates signify the opposite. By examining cap rates, investors can weigh the risk versus returns on different properties and make more informed decisions. However, there are many other factors to consider, such as market value and taxes. A low cap rate is often associated with a lower level of risk, whereas high cap rates come with a higher level of risk.

Regarding leverage, the most important thing to remember about cap rates is that they give investors a rough idea of how much income a property will generate, and reflect a blend of Return on Equity (cash from the investor) and Return on Debt (interest on a mortgage). Leverage works when money to acquire a property can be borrowed at an interest rate lower than the overall return (Cap Rate) on an investment property, magnifying the Return on Equity. It’s worth noting, however, that when the commercial real estate supply is low and demand is high, investors will often tolerate decreased returns, especially in periods of low interest rates.

Forecasting the Future of the Commercial Real Estate Industry

It’s difficult to predict the future of interest rates in 2023. According to Bankrate, 10 Fed officials are predicting one more rate hike. A few other officials say we could see even more rate hikes this year. This could present a tricky situation for commercial real estate investors, especially those who are relying on leverage. However, much depends on inflation forecasts and pricing stability after the collapse of two banks this year. Growth in retail and office sectors has declined since fewer people are commuting to work. However, there is a growing need for multifamily properties and industrial spaces.

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