The Impact of Rising Interest Rates on Commercial Real Estate: What Any Colorado Hard Money Borrower Should Know
In addition to death and taxes, one certainty of life is that the interest rates that went down will eventually come back up. After the economic collapse of 2008, interest rates hit rock bottom and have stayed there ever since. As the economy recovers, it is not a question of if interest rates will rise, but when and how much? It’s nearly impossible to predict the answers to these questions without a crystal ball, so rather than focusing on fuzzy predictions, it is more helpful to be aware of the potential impact of this inevitable rise on the commercial real estate industry.
Interest rates are closely tied to supply and demand within the industry. This is best illustrated by looking at the relationship between interest rates and capitalization (cap) rates. An easy formula to determine cap rates is A (total income from the property minus operating expenses) divided by B (price the buyer is willing to pay for the property) equals C (convert to a percentage and this is the cap rate). The more stable the potential income of the property, the lower the cap rate, and the higher the price an investor is willing to pay. Cap rates generally follow the upward or downward trend of interest rates, but they are still working to catch up in the aftermath of the recession. The increase in interest rates will drive demand up and supply down, this will raise asking prices and bring cap rates back into correlation with interest rate trends.
As a Colorado hard money borrower, there are a few key things to keep in mind about the impact of interest rates on your investments and projects.
- Rising interest rates increase the cost of new construction and overall market absorption rates.
- This leads to a decrease in the number of new construction projects, resulting in a “landlord’s market” with fewer properties available to purchase, allowing owners to charge higher rent.
- Thus, property owners profit, while developers and tenants are negatively impacted.
As interest rates increase, real estate tends to become a less desirable alternative to other types of income producing assets with less perceived risk. The higher cost of overall capital combined with a reduction in LTV rates will result in a shift from the current “borrower’s market” to an “investor’s market.” This harsher environment will weed out weaker developers and force out individual buyers as default rates climb and debt service obligations grow.
In order to survive or flourish in this kind of financial climate, it will increasing become advantageous to switch from short-term floating rate loans to longer-term fixed rate loans and to ascertain that assets have potential for Net Operating Income (NOI) growth. The 64 trillion dollar question is when.
This blog was written by Bob Amter, President of Montegra Capital Resources, LTD., a Colorado hard money lender. Bob has been in the private capital lending business for 41 consecutive years.