As interest rates continue to climb, many are curious about what kind of negative effect it will have on the commercial real estate market. Will the climbing interest rate cause CRE transactions to yield less return? How will property values and investment performances fare? Investors are beginning to fear that higher interest rates will result in capitalization rates to rise and property values to decrease, producing lower returns.
Let’s take a look at how rising interest rates will really affect commercial real estate.
How Will Higher Rates Impact Returns?
Rising interest rates have a potential impact on investment returns across all asset classes. Investors are wary that higher rates could decrease property values and operating income by increasing discount rates and slowing down the economy. These fears come from the idea that rising rates result in higher cap rates, which will weaken CRE investment performance and property values.
The good news? Higher interest rates do not automatically produce lower returns on CRE investments. The relationship between the CRE returns and the rates are affected by many different factors including the economic environment. From December 1995 and April 1997, the 10-year yield increased 118 basis points and the one-year forward cap rate lowered by 63 basis points and the current NOI growth increase by 3.5%. The total investment returns increased by 36% and property values increased by 10%.
This data shows that rising rates will not necessarily squash the opportunity to gain high return on CRE investments, but they do often correlate with positive economic conditions that improve the performance of the commercial real estate sector.
Do Rising Interest Rates Mean Higher Cap Rates?
The cap rate is the ratio of the building’s net operating income to market value and is the most sensitive way to price commercial real estate. While this formula assumes that higher interest rates produce higher cap rates resulting in lower property values, it is important to note that the relationship between interest rates and cap rates are strongest when you compare longer timeframes. Cap rates are ultimately influenced by capital flows, investor risk interest, real estate fundamentals and so forth.
Because of this, the effect of rising interest rates on commercial real estate performance is tough to predict. Historically, changes in Treasury yields have not resulted in immediate changes in cap rates.
Net Operating Income Growth in 2019
NOI growth is slowing its pace, but it is projected to exceed its long-term average in 2019. Commercial real estate market conditions are positive and the majority of leases maturing in 2019 are below market and those who lease these spaces next can lease for higher rents. NOI growth is something investors consider highly when looking to obtain investments with high appreciation.
As we look toward the future of commercial real estate in 2019, we can only hope that the interest rates rise gradually so that the market can be well-prepared and adapt quickly. Higher rates generally indicate a strong economy, which often is associated with a strong real estate market.