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Interest rates are on the rise. This may be discouraging to some real estate investors, but it shouldn’t derail your plans for profitable commercial real estate (CRE) investing. Learn more about current trends with rising interest rates in commercial real estate and how you can expertly navigate this development in the market.
Effects of Rising Interest Rates on the Commercial Real Estate Market
Rising commercial loan interest rates have affected the CRE market in many ways. Let’s look at some of the main effects we’re seeing.
The market is cooling off but still thriving.
Rising interest rates’ effect on real estate has certainly been felt, but these rates have by no means devastated the market. They have simply caused the market to cool a bit, creating more opportunities for serious investors as competition wanes.
Despite the headwinds, the CRE market is expected to continue performing well overall, according to the National Association of REALTORS. Experienced investors understand that commercial real estate interest rates right now are not unusually high but are very reasonable and more in line with historic norms.
Loan costs for commercial borrowers are higher.
The most obvious effect of rising interest rates on commercial borrowing is the higher cost of debt. As loans become more expensive for borrowers, they must become more discriminating in the projects they’re willing to include in their portfolio in order to remain profitable. Real estate transactions can no longer depend only on low-cost capital.
Cap rates are rising, and property values are lowering.
Higher commercial loan interest rates are also linked to a decrease in property values due to widening capitalization (“cap”) rates. Cap rates are the ratio of net operating income (NOI) to property asset value (without factoring in financing). Another way to think of cap rates is as an unlevered rate of return.
How is this related to interest rates? Because of the increased cost of borrowing, the rate of return on a property also needs to rise in order for investors to maintain the same level of profitability. To achieve these higher returns, property prices must fall. Hence, downward pressure is exerted on property values as cap rates rise.
Factors That Affect Individual Interest Rates
Market norms aren’t the be-all and end-all in predicting an individual’s interest rate on a loan. Different loan structures and types can offer very different interest rates. Generally, the interest rate is closely tied to the level of risk the lender takes on for a given transaction.
While your personal credit history and finances are factors, in nonrecourse lending, the property or investment opportunity itself plays the most important role in helping underwriters determine appropriate interest rates. A solid business plan with low levels of risk and a high potential for return will justify a more favorable interest rate.
Advice for Borrowers Navigating This New Normal
Commercial borrowers can still thrive in the current market despite the return to normal commercial loan interest rates. Follow these principles for strategic and cost-effective commercial real estate borrowing.
1. Don’t have your business strategy rely on low-cost capital.
Any real estate investor must be prepared for changing interest rates. If a higher interest rate is enough to derail your business plan, you may need to adjust your strategy.
Many investors will need to become choosier about the properties they’re willing to invest in. Debt should be used to gain positive leverage to maximize an investor’s return. To gain this leverage, investors must calculate their loan constant and ensure the property offers a cap rate that exceeds this loan constant.
Make sure your expectations and strategy are in line with current interest rates. Though it’s impossible to predict exactly what will happen in the future, you should stay apprised of market norms and ensure you’re financially prepared for the cost implications.
2. Don’t let interest rates dictate the loan you choose.
Interest rates should not top your list of factors when choosing a loan. Real estate financing is extremely situational, so it’s always best to look for a loan designed specifically for your situation and strategy.
The more dynamic the situation, the less important the interest rate ultimately is. For instance, a bridge loan may come with higher interest rates than longer-term financial products, but these interest rates will only affect you for a short time until the loan matures, and the capital can help you achieve more profitability.
If you find a promising loan that will help you meet your goals, but your quote includes an interest rate that isn’t your ideal, it may still be the best option for your situation.
3. Pay attention to transaction costs.
Interest rates tend to be top of mind for many investors, but it’s important to keep in mind that a loan’s interest rate isn’t the only aspect of the loan that can affect its total cost.
Application fees, closing costs, and prepayment penalties are all examples of costs that are independent of your interest rate. As you search for favorable interest rates, don’t forget to look for a loan that minimizes these extra costs in order to offset the total cost of debt.
Find the CRE Loan You Need to Achieve Your Investment Goals
The market is experiencing some changes, but there’s still a wealth of opportunities for commercial real estate investors.
Verus Commercial Real Estate is a trusted CRE lender with flexible loan products to fit a variety of situations. Learn more about our Short-Term Bridge Loan and our Intermediate Bridge Loan, and get started by applying today!
