Posted on July 26, 2024
Impact of Rising Interest Rates on Commercial Property Values
Interest rates play a significant role in the commercial real estate market, influencing everything from property values and development activity to financing costs and investment decisions. Recently, there has been a noticeable increase in interest rates as central banks aim to manage inflation and stabilize the economy. The Federal Reserve increased the federal funds rate from near zero in early 2022 to a range of 5.25% to 5.50% by mid-2023. This significant rise is part of the broader strategy to combat inflation, which peaked at 9.1% in June 2022 but has since moderated to around 3.5%.
Understanding the relationship between interest rates and commercial property values is essential for investors, property owners, and appraisers. Higher interest rates generally lead to increased borrowing costs, which can reduce buyer demand and lower property values. Conversely, lower interest rates can boost demand and elevate property values. At LPA, we emphasize the importance of our appraisers having a comprehensive and current understanding of these dynamics to provide accurate and insightful property valuations. In this article, we will dive into the issue and shed some light on this complex topic
Impact of Rising Interest Rates
Higher Borrowing Costs
Rising interest rates lead to higher borrowing costs, often reducing the demand for commercial properties. As financing becomes more expensive, potential buyers may find investments less attractive, which can ultimately lead to lower property valuations. Historically, higher interest rates have been correlated with lower sales transactions.
Decreased Property Income
Higher financing costs can reduce property income due to increased mortgage payments, especially for those with adjustable-rate mortgages. Additionally, higher interest rates can lead to increased cap rates and reduced net operating income (NOI), both of which negatively impact property values. Increased mortgage payments can cut into NOI, affecting overall property profitability. This reduction in NOI can make properties less attractive to investors who rely on steady income streams.
Effect on Development Activity
The impact of rising interest rates also extends beyond existing properties and into new developments. Higher interest rates can increase the cost of construction loans, making it more expensive to finance new projects. This can lead to a potential slowdown in development activity as developers may delay or cancel projects that no longer appear financially viable. According to Plante Moran, the cost of debt has risen nearly 300 basis points over the past year, significantly affecting new real estate development due to the difficulty of finding financing sources that fit within a project’s capital stack. This has led to a compression in building valuations across commercial sectors.
The Inverse Scenario – Falling Interest Rates and Property Values
Lower Borrowing Costs
When the Federal Reserve lowers interest rates, borrowing costs often decrease, making it more affordable to finance commercial properties. Lower interest rates can stimulate demand, leading to increased property values. Historical data shows that periods of falling interest rates have often resulted in a surge in commercial real estate investments. During the early 2000s, the Federal Reserve’s low interest rate policies contributed to a significant increase in commercial property values across major markets.
Increased Investment Activity
Lower interest rates can lead to higher demand and increased property values as more investors can afford to purchase properties. Historical examples, such as the period following the 2008 financial crisis, demonstrate how lower interest rates led to significant appreciation in commercial property values and increased market activity.
Financial Implications for Property Owners
Property Taxes and Insurance Costs
Interest rate changes can significantly affect property taxes and insurance costs as property values adjust. When interest rates rise, property values decrease, leading to lower property taxes. However, the converse is also true: falling interest rates can boost property values, leading to higher property taxes. Additionally, higher interest rates can increase insurance costs due to the increased risk perceived by insurers.
Mortgage Payments and Refinancing
Interest rate fluctuations directly impact mortgage payments and refinancing options. Higher rates lead to higher mortgage payments, making it more challenging for property owners to manage cash flow. Refinancing options become less attractive as higher rates can negate the potential benefits of refinancing. Conversely, falling interest rates present opportunities for property owners to refinance their mortgages at more favorable terms, potentially lowering monthly payments and improving cash flow.
Rental Income and Lease Terms
Interest rates can also influence rental income and lease terms. Higher rates make it more expensive for businesses to borrow money, which can reduce their ability to expand or lease new spaces. This can lead to increased vacancy rates and pressure on rental income. Conversely, lower interest rates can make it more affordable for businesses to expand and lease additional space, potentially leading to higher occupancy rates and increased rental income.
Operational Costs and Maintenance
Additionally, interest rate changes can affect operational costs and maintenance expenses for property owners. Higher rates can lead to increased costs for loans and lines of credit used for property maintenance and improvements. Property owners may feel the need to reassess their budgets and potentially delay or scale back planned maintenance projects during periods of rising interest rates.
The Role CRE Appraisal Firms Play
Expertise and Guidance
Commercial real estate appraisal firms, like LPA, help property owners understand the impact of interest rate changes. Our appraisers provide expert analysis and valuations that consider current and projected interest rate trends, enabling our clients to make informed financial decisions. Appraisal firms assist property owners in developing both short-term and long-term financial plans by understanding how interest rates affect property values, rental incomes, and operational costs. They also play a crucial role in risk management by analyzing how interest rate fluctuations impact different aspects of property ownership and advising on the best approaches to mitigate these risks.
Client-Centric Approach
At LPA, we prioritize our clients’ needs, ensuring that our appraisers are always abreast of the latest market trends and interest rate projections. This enables us to provide the most accurate and relevant advice. Andrew Burns, Senior Associate Researcher at LPA, explains, “By supplying our clients with the latest market insights and information, we can assist them in understanding the intricacies of the commercial real estate market and enable them to make highly informed choices.” Danielle Watkins, MAI, Managing Director at LPA, adds, “During times of uncertainty and rising costs, it is increasingly important to stay on top of market trends, and to make sure we are providing the most up-to-date data to our clients.” This client-centric approach ensures that property owners receive personalized advice tailored to their specific situations.
Rising interest rates can significantly impact commercial property values by increasing borrowing costs and reducing buyer demand. Property owners face various financial implications, including higher mortgage payments, increased property taxes, and potential decreases in property income. These challenges underscore the importance of strategic financial planning and risk management. Conversely, falling interest rates can boost demand and elevate property values, presenting opportunities for refinancing and improved cash flow. Historical data shows that lower interest rates can lead to increased investment activity and higher property values, making it crucial for property owners to stay informed about interest rate trends and their potential impacts.
Engaging with a commercial real estate appraisal firm, such as LPA, can help property owners manage these financial responsibilities and develop strategic plans. Our expert appraisers provide accurate property valuations and valuable insights into market trends to ensure our clients are well-prepared for economic changes. Contact us today for your commercial real estate needs.
