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Let me start by stating that almost all commercial real estate transactions depend on financing in some way, shape, or form. Whether you are purchasing, refinancing, or developing a property, interest rates should be a part of your overall calculations. Why? Because even the most minuscule changes in rates can affect your debt service or a project’s overall feasibility. How? As rates increase, borrowing becomes more expensive, which often reduces purchasing power. On the flip side of the same coin, as rates decline commercial real estate projects become more affordable and the pool of buyers tends to increase. Knowing where the interest rates are and where they may be going allows for better navigation in commercial real estate deals.
If you read my previous article, then you’ll know that I’m a big promotor of capitalization rates. They are a primary method of establishing a property’s value. Interest rates strongly affect capitalization rates. When interest rates rise, investors generally require higher returns to offset the increased borrowing costs and risk, which ultimately leads to higher cap rates and lower valuations. When interest rates come down, cap rates tend to as well. This little tug-o-war relationship between higher and lower interest rates can create discrepancies between buyers and sellers. As an example, as interest rates go up buyers further scrutinize what they deem to be acceptable returns on their investment to offset the increased rates. But if sellers are not adjusting their values based on the same interest rate increases then there will undoubtedly be a difference in their overall evaluation of the same deal. We aren’t talking about huge hikes in interest rates either. A few basis points in either direction can make or break an entire deal!
This all shouldn’t be new news. Higher interest rates = fewer overall transactions. Sure, we get that, but higher rates also create a domino effect. Higher rates leads to fewer transactions and fewer transactions will limit the comparable sales data because of fewer deals, making pricing more difficult, and negotiations unavoidably more complex. Subsequently, the ‘pool of monopoly players’ is affected because entry level investors and some owner-users will have a harder time qualifying for loans when rates are higher. Which is why monitoring interest rates is so essential – because they affect everything.
Any property owners with an adjustable-rate loan should be even more mindful of rising rates. If you are refinancing debt you will want to know how any changes to your existing loan’s interest rate will alter your cash flow. Forecasting based on interest rate trends is like trying to hit a moving target BUT it’s very unlikely we’ll see, or return to, the historically low interest levels seen during the COVID pandemic. Meaning if you took out a loan about five (5) years ago, and are approaching a loan adjustment, it’s safe to assume your new rate will be higher and you should prepare accordingly.
In truth, this article could expand pages but that is also why we have educated lenders, brokers, and financial planners. These professionals should be consulted before taking any big swings in the market or with an existing loan. Knowing that a single basis point can make or break a deal is half the battle. The other half determines how to work thru or around any constraints. Lastly, the federal reserve releases interest rates constantly and you can find those by going to www.federalreserve.gov.
Sincerely, Vince Campana
Associate Broker
Campana Waltz Commercial Real Estate West
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