Navigating Commercial Real Estate
Navigating Commercial Real Estate in a Shifting Landscape
As a recap from Part 1 - Residential Market : In the ever-evolving landscape of real estate, there is one constant that can make or break a deal, shape market trends, and influence investment decisions: interest rates. The relationship between interest rates and the real estate sector, both commercial and residential, is intricate and profound.
So why is everyone talking about interest rates? At its most simplistic definition, what are Interest rates? Interest rates, typically set by central banks, determine the cost of borrowing money. When rates are low, borrowing is more affordable, leading to increased demand for real estate. Conversely, when rates rise, borrowing becomes more expensive, potentially cooling the market.
Even deeper than that, in today’s environment, when rates rise sharply, lending criteria changes, banks change monetary policy, rates for borrowing and investing start doing odd things and don’t relate to one another like they do in a “normal” economy.
Impact on Cap Rates: One of the fundamental metrics that commercial real estate investors track is the capitalization rate (cap rate). Cap rates are influenced by a variety of factors, with interest rates playing a significant role. When interest rates rise, cap rates often follow suit. This, in turn, can lead to decreased property values. A wise old investor once shared a simple formula: Cap Rate = Base Rate (use 3%) + 1% Risk + 1% Profit. When cap rates dip below 5%, it's a red flag that something in this equation is awry. If you've acquired a property recently, it's time to reassess your refinance strategy as commercial rates have surged from 4% to 8%.
Financing Costs: Commercial real estate transactions frequently involve substantial borrowing. Investors often leverage their capital to maximize the number and volume of deals they can undertake. However, as interest rates rise, the cost of financing these projects increases. This can potentially eat into profitability. Moreover, lenders have become more cautious, scrutinizing proformas with newfound vigilance. Investors may need to be more selective in their choices and seek higher returns to offset the rising borrowing costs.
Market Dynamics: Not all sectors within commercial real estate react the same way to interest rate fluctuations. For instance, higher rates might adversely affect demand for office spaces, while industrial or warehouse properties could remain resilient thanks to the growth of e-commerce. However, a new factor has emerged that significantly impacts lending in these markets. Lenders find themselves in an unusual predicament due to changing market dynamics. When a lender borrows money from depositors at a higher rate than what they lent it for, it leads to an unfavorable situation. This situation can result in lenders making adjustments, such as increasing CD rates and scrutinizing new loan and refinance requests more closely to shore up their financial books.
A new factor has emerged in this last market that is also significantly impacting lending in these markets. The lenders, who really just lend their depositors deposits, find themselves in an upside down market. For example, let’s say you deposited $100,000 with the bank two years ago. Last year, that lender lent that money to someone at the market rate of 4%. This year, you decided to withdraw your money. Now the lender can’t go get your money from the borrower and if they don’t have other deposits to cover your withdrawal, they borrow that money from the Fed (currently at 5.3%) and lose 1.3% in that exercise. No lenders business models, like many others, do not favorably respond to losing money. They will make adjustments like increase CD rates and other things to incentivise people to deposit their money. THey will also look closer at new loan and refinance requests to “shore up” the books.
So as we now move forward and talk about the current real estate market, we need to be mindful of these “invisible hands” that influence the markets. It’s not always about a seller setting a price right or a buyer crafting the right offer. Our market has a host of anomalies that influence its movement.
With all of those factors, what can you do?
Stay Informed: Keep a close eye on central bank policies, interest rate forecasts and your market metrics to anticipate market shifts. Have days on market recently changed or the number of listings available? Metrics matter as we plan for future moves!
Diversify: Spread investments across different property types and locations to mitigate risk associated with interest rate fluctuations. Look at loan maturity dates, project cash flow needs and prepare for the next year or two as the market stabilizes.
Long-term Perspective: Consider longer-term financing options to lock in lower rates, especially when rates are historically low. Build your war chest and look for investment opportunities as there will be properties that need to sell for various reasons related above. Also, there will likely be less competition for these investments.
Risk Management: Develop contingency plans and stress-test investment strategies to assess their resilience in different interest rate scenarios. A sound financial plan will enable you to make management decisions confidently and keep you from finding yourself short.
As we navigate the current real estate market, it's crucial to recognize these "invisible hands" influencing its movement. It's no longer solely about sellers setting prices or buyers crafting the right offers. Instead, our market is now shaped by anomalies that demand a nuanced understanding.
In conclusion, adaptability and foresight are essential in today's commercial real estate landscape. Investors should continuously monitor interest rates, adjust their strategies accordingly, and be prepared for changes in market dynamics. By doing so, we can effectively navigate the ever-evolving world of commercial real estate and make informed decisions that lead to long-term success.