Interest rates are a key factor in determining how much you’ll pay for commercial investment properties. Understanding the correlation between mortgage interest rates, cap rates, and property values can help investors make more informed decisions when buying, selling, or holding their commercial investment assets.
In this article, we’ll examine how rising interest rates can potentially increase risk for your commercial investment portfolio.
Factors That Drive Interest Rates
Let’s take a look at the primary factors that drive interest rates:
- Supply and demand for U.S. Treasury bonds
- The Federal Reserve
The inflation rate plays a large role in gauging the health of the U.S. economy. Rising inflation can erode consumer confidence in their purchasing power, leading to higher interest rates to cover this loss. Increased demand for U.S. Treasury bonds also can bump interest rates, as can moves by the Fed to suppress interest rates by buying bonds to inject capital into the economy.
When interest rates rise, it costs more to borrow capital, which can reduce profit. However, other factors also affect the overall performance of commercial assets.
How Interest Rate Risk Impacts Commercial Real Estate Investments
The value of your commercial portfolio is affected by long-term interest rates, such as the U.S. Treasury 10-year rate, which impacts cap rates used in commercial real estate valuations. Prevailing long-term rates influence cap rates when investors bid on commercial assets, and market cap rates typically have a spread versus long-term rates that reflect risk premium.
As returns on bonds and mortgage-backed securities rise, investors subsequently require an increased rate of return on their real asset investments. This rate of return can be determined by the capitalization rate, or cap rate, which is the net operating income of your investment property divided by its value or price. Rising cap rates lead to lower property values, while compressing cap rates mean increased values.
Cap rates typically increase as interest rates rise since there’s now additional risk to investors -- the value of future cash flows declines, which also drops the value of investment properties. However, the relationship here isn’t so simple. Other factors, such as solid net operating income (NOI) growth, can act as a buffer between rising interest rates and declining property values. The greater the NOI growth, the stronger this buffer becomes.
Timing also is an important consideration. Short-term increases in cap rates are more quickly noticeable in your investment property’s valuation; however, the performance of any given asset is often less sensitive to cap rate fluctuations over the long term.
Assessing Interest Rate Risk
Fixed-income assets such as commercial real estate offer portfolio diversification, as well as the potential for capital appreciation and robust income. Assessing interest rate risk, as well as commercial assets by grade and location, can help investors identify a property’s strengths, weaknesses, and mitigate the impacts of fluctuating interest rates.
Managing interest rate risk, however, can be difficult. Investors who perform rigorous due diligence, weigh the many variables that determine interest rates, and borrow responsibly can be better insulated from the risk of rising interest rates.
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