May 20, 2022

How Will the Fed Interest Rate Hikes Affect Commercial Real Estate?

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We were warned it was coming … and now it’s here. After not touching the Federal Funds Rate since 2018, the Federal Reserve finally raised this key interest rate by .25 percent in March of 2022 and another .5% only a month later in April. So it’s official — the tide is starting to roll back on the era of bargain-basement interest rates.

Of course, interest rates make the commercial real estate world go-'round … but the Fed can’t just push a button and make commercial mortgages more expensive. The APR available to borrowers at any given time depends more on demand for mortgage bonds, not the whims of the Fed.

So what effect, if any, will the recent interest rate hikes have on CRE.

First Things First … What Did the Fed Do, and Why?

The Federal Funds Rate is the rate at which banks can make overnight loans to each other. Raising it makes this process more expensive, incentivizing banks to limit the amount of money they circulate. 

This is the Fed’s prescription for an overheated economy, characterized by galloping inflation — reduces money flow, so things cool down a little. 

What Impact Might This Rate Increase Have on Commercial Real Estate?

Tighter Underwriting, Smaller Loans

While commercial mortgage interest rates may not be directly affected by the Federal Funds rate, restrictions on money flow between banks may mean less money to lend. This may mean that commercial lenders will become pickier about who they lend to, issuing debt only to experienced and well-capitalized borrowers. 

It may also mean smaller loan-to-value — lower debt balances. While lower debt service payments mean more cash flow (unless mortgage interest rates increase), less leverage means less exposure to appreciation and downward pressure on overall ROI (Return on Investment).

Upward Pressure on Cap Rates…With a Catch

If the debt becomes scarce and expensive, it will take a lower price to achieve the same ROI. So what does that mean in commercial real estate math? First, higher capitalization rates will produce lower property values.

So will real estate property values crater? Not necessarily. Due to inflation and other factors, demand for commercial real estate is at an all-time high. Inflation also makes pre-existing debt less valuable. 

Rising NOI (Net Operating Income)'s plus intense demand create upward pressure on cap rates. So while we might see prices level off a little, a precipitous flattening or drop is unlikely.

Possible Increase in Renters 

Inflation and higher mortgage costs may price many aspiring homeowners out of the market, prompting them to become renters or stay renters. This may increase the demand for multifamily leases, which puts upward pressure on rental rates. 

Again, existing debt becomes less valuable due to inflation, so multifamily real estate may enjoy continued pressure upward, even if prevailing cap rates do rise.

Of course, nothing is guaranteed in finance and investing. The mechanics of the Federal Funds rate makes lower valuations more likely, but every deal is different, and no one factor governs the real estate market. As always, we’ll know when we close.

If you would like to invest in real estate and obtain more information, please email us at invest@infinity.re.

Nason is responsible for identifying and assessing real estate development and acquisition opportunities. He has experience acquiring and managing over $500m of opportunistic real estate investments along the east coast.

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