Understanding the Impact of Interest Rates on Commercial Real Estate: A simple breakdown
The Fed increased its lending rate by a quarter-point in July to a range of 5.25% to 5.5%, the highest level since 2001. Additional rate increases would likely further stress a strained economic situation in the commercial real estate market.
In the world of finance and real estate, interest rates play a huge role in shaping how things work. Think of them as the temperature of the money market - when they rise or fall, they can cause ripple effects that touch everyone, from big businesses to everyday people.
Over the past year, there's been a big shift: interest rates have been on the rise. While these rates might still seem okay when we look at them in the context of history, their quick ascent has stirred things up. Specifically, in the commercial real estate sector, both fixed and floating-rate lending (ways in which businesses borrow money) have taken a hit. Imagine you're used to seeing a price tag of $10, and then suddenly it's $15 or $20 – that's the kind of surprise, or "sticker shock", borrowers are experiencing. This is not just because of the interest rates themselves, but also due to the rising costs of tools businesses use to protect themselves from these rates, like interest rate protection agreements.
So, even if you don't get all the nitty-gritty details, the key takeaway is that as interest rates go up, borrowing gets pricier, which can shake up the real estate world. Here it is, in very simple terms…
Loans Get More Expensive:
If interest rates go up, borrowing money costs more. For example, if you had a loan of $10m at 5% interest and the rate goes up by 1%, you'll pay $100k more each year. Some property owners might struggle to pay back their loans or will have less money for other stuff.
Less Profit From Property:
When borrowing is more expensive, the profits from owning property can decrease. Before, when borrowing was cheap, you could use loans to make more money. But now, borrowing can reduce your profits. So, owners have to think hard about whether borrowing is still a good idea.
Property Prices Drop:
Higher loan costs mean less demand for property. So, prices can go down. This can be because people look for other investments or because they just can't afford those high prices anymore. While this is bad news for some, others might get a chance to buy property at a lower price.
Economic Growth Slows Down:
When businesses have to pay more to borrow, it's more costly to run them. This can lead to higher prices for things in general, which means people spend less. Plus, with changes from COVID-19, businesses might cut costs by using less commercial space.