The Impact of Rising Interest Rates on Commercial Real Estate
With interest rates being a major factor in commercial real estate returns, many investors fear what high rates, with cap rates following, could mean for their existing portfolios.
In this blog, Excelsior VP of Investments, William George, addresses the impact of increasing interest rates and ways to minimize risks – and even find opportunity – in today’s economic environment.
Investment Approach is Critical
In the short-term, we have to accept a different interest rate reality; debt options are simply not as strong as they were 12 to 18 months ago. As such, it’s important to be disciplined on the underwriting side and account for this shift. More importantly, there’s an even greater need to focus on high quality properties located in exceptionally strong, resilient markets.
As an investor, you should not sacrifice quality for riskier assets or markets with the potential for higher returns in an environment like we’re experiencing today. Rather, you’ll want to invest in opportunities and locations that you feel confident in, regardless of the economic environment. Strong opportunities will continue to present themselves if you remain disciplined in your approach.
Offsetting Rising Rates
In the long-run, the current interest rate environment is not something to be highly concerned about. Lender spreads should naturally come in a bit to offset the increase in rates as demand for financing softens, and as volatility falls off. There could be some moderate cap rate expansion in certain asset classes or markets as liquidity tapers off, but it’s expected that demand (and therefore cap rates) will persist and continue to grow for quality assets in markets with strong real estate and demographic fundamentals (Nashville being a great example).
It’s also worth noting that if the growth in the area continues as expected, rental rates are likely to be substantially higher than what’s been modeled for in the later years. If that is the case, NOI is higher, which in return would offset the effects of a higher cap rate.
At Excelsior, our investments’ success does not hinge largely on exit value, which is why there are still many strong opportunities, even if cap rates were to expand.
On the rental rate front, inflation is generally a favorable dynamic for landlords, and we are seeing this play out at some of our properties; therefore, we feel good about our ability to meet our debt service over the long term. We aren’t in multifamily where you can mark-to-market leases every year, but with almost all of our investments, we also aren’t dealing with 7+ year lease terms either. This allows us to gradually increase our rates and keep up with the market over time. Additionally, 90%+ of our leases have rental increases year-over-year as well, which helps offset some of the effects of inflation. (Learn more about rent rolls here.)
What does this mean for Commercial Real Estate Assets?
No one has a crystal ball, but when inflation starts to show signs of slowing (which many think is occurring now), and the events from Russia begin to stabilize, we should see much more stability across the economy and our debt markets.
The good news is – commercial real estate performance is much more closely aligned to growth than inflation. Inflation, in itself, is not critical for the asset class, and with long-term appreciation for most commercial properties, investors can rest assured that their investments are positively positioned for success, both now and when the economy recovers.
If you have any questions or would like to learn more about our investment strategy, please don’t hesitate to contact us!
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