Commercial Real Estate’s Interest in Interest Rates
From early 2022 to mid 2023, the Federal Reserve continually raised interest rates in an effort to quell inflation. In 2024, rates have remained stubbornly high and activity in commercial real estate has significantly dropped as a result. Today we chat with Chris Grobelny, Chief Financial Officer of Premier Commercial Realty, about the current interest rate environment and the impact of financing properties in the commercial real estate industry.
The commercial real estate industry has witnessed a historic rise in interest rates over the past couple of years. In an effort to curb inflation, the Federal Reserve started raising interest rates in March of 2022, and finally stopped in July 2023 (11 increases). The chart below from the New York Federal Reserve website shows the timing of the increases as well as their accelerated pace. The target fed funds rate went from a range of 0%-0.25% to 5.25%-5.50% at the time of writing this article. The cost of capital being higher will directly result in fewer transactions as the yields on investments have not increased as much as the cost of capital. The purchase prices paid for real estate will ultimately fall, as there will be a natural reduction in the demand for properties.
Is it easier or harder to invest in today’s world?
The answer to the question depends on the investor. All deals work with a particular set of metrics, and, regardless of higher interest rates, mathematics and financial fundamentals will always prevail. For example, if a property is purchased for $1 million dollars and Net Operating Income (NOI)1 is $100,000 a year from that property, this is a 10% return on the investment (if paid 100% cash). To enhance those returns, an investor will leverage 75% of the purchase price. In March of 2022, the cost of debt would be about 4%. In this example, $750,000 amortized over 20 years is costing the borrower $54,500 a year. This results in net cash flow of $45,500, providing an 18% return on the investment. The leverage made this deal even better – obtaining an 18% return vs. paying all cash and getting 10%.
In today’s financial world, using the same metrics, the only difference is the cost of capital. The interest rate today may be 7.5% or higher. This same investment now calculates to $72,500 in debt payments, reducing net cash flow to $27,500 a year, or an 11% return on investment. That is not a bad return, but it is much less than the 18% return in 2022. To get the same 18% return in today’s rate environment, one would need to purchase the same property at $850,0002 resulting in a reduction in property value. Alternatively, an investor can pay the same price ($1,000,000) and accept that the returns will not be as high as they were two years ago for the same asset.
Today, most sellers will not accept this reduction in value. On the other side of the equation, buyers feel there is hope for short-term interest rates decreasing in the coming year. There is a tactical approach needed to purchase properties today and a delicate balance of valuation and expectations between the two parties.
Is cap rate still a good metric to utilize when evaluating a property, or are there better metrics to utilize in this current market environment?
The cap rate is a great metric to use in real estate and is one of the classic measures of valuation. The cap rate is derived taking the gross income minus operating expenses to obtain the Net Operating Income (NOI). The NOI is divided into the Purchase Price to calculate the Capitalization Rate, commonly known as the “Cap Rate”. The cap rate can be compared to riskiness. The riskier the investment, the higher the return investors want to achieve.
This calculation is prior to any loan payments or non-operating expense items that are calculated below the NOI line. It allows you to compare different buildings at a glance and quickly determine how the asking price is valued based on the rent. The cap rate is a still a good metric to use and measure value compared to Return on Investment (ROI) because the ROI is determined after debt service, which can vary widely. Some banks lend 80% of the purchase price while others lend only 60%, and some investors will choose to purchase completely in cash. The cap rate is used industry wide and will always be an important metric in real estate investing.
Since real estate is cyclical, what do you anticipate happening in the industry over the next several months/years?
Real estate is certainly a cyclical industry which is influenced by various economic, social and political factors. While it is challenging to predict with absolute certainty, several trends and factors can give a glimpse of what might happen in the real estate market over the next several months to years.
If the Federal Reserve continues to raise interest rates to combat inflation, mortgage rates are likely to increase further. Higher mortgage rates reduce affordability, potentially cooling down demand and slowing price growth. Some markets may experience price corrections as buyers adjust to higher borrowing costs. This could lead to a slowdown in transaction volumes.
There are also continuous ongoing economic uncertainties, such as those related to global trade issues, geopolitical tensions, or a potential economic downturn, and these factors can impact buyer and investor confidence. Employment rates are also a factor, as high employment rates support housing demand. Conversely, rising unemployment can dampen demand.
Supply chain and construction costs can be devastating to the progress and timeliness of projects. Higher material costs and continued supply chain disruptions can impact construction completions. Limited supply with steady demand can maintain upward pressure on prices. All these variables can alter the future direction of the economy and real estate industry.
1: The NOI is the annual income expected from rent minus the expenses for managing the property. This includes Insurance, taxes, Common Area Maintenance, etc. but not debt service
2: Assuming 7.5% interest rate on the same 20-year amortization. Cash out of pocket is now $212,500 vs $225,000 with $637,500 financed
About the Author
Chris Grobelny joined the Premier team in September 2023 bringing with him more than 30 years of experience in both real estate and finance. As CFO, Chris will focus on expanding debt and equity sources for growth in Ohio and strategic locations across the country.
