The Two Main Ways Higher Interest Rates Will Impact Commercial Real Estate

Industrial property valuations have risen consistently over the past several years, and the lack of supply has driven prices rapidly higher over the past 9 months. One of the main drivers of demand has been the owner-user who utilizes SBA financing by putting 10% down to purchase a property. For these buyers, purchasing a property at 10% down fixes their occupancy cost and is cheaper when factoring in principal reduction as opposed to leasing. Also, investors who finance their purchases can accept a lower return when the cost of capital is near all-time lows. However, the Federal Reserve has indicated it will raise interest rates another 4-5 times this year after its most recent rate hike this month. Higher interest rates could impact the demand for industrial properties in the long run. Below are the two main ways higher interest rates will impact commercial real estate.

1.     Higher occupancy cost for owner-users

Owner-users who finance their purchases with SBA financing will be paying more in interest for their purchases as interest rates rise. Consider the following example, financing $2,250,000 for a 10,000 SF industrial building over 25 years at the following rates:

·       2.5% Interest Rate ($2.25M Loan) 2020 Loan Rate:

Monthly Payment:                      $11,923

Interest paid in year one:            $55,248.20

Interest paid in years 1-5:            $253,462.49

·       3.5% Interest Rate ($2.25M Loan) Current Loan Rate:

Monthly Payment:                      $13,049

Interest paid in year one:            $77,489.12

Interest paid in years 1-5:            $358,293.59

·       5% Interest Rate ($2.25M Loan) Potential Future Rate:

Monthly Payment:                      $14,849

Interest paid in year one:            $110,973.54

Interest paid in years 1-5:            $518,674.69

While utilizing SBA financing will still be beneficial at higher interest rates, the increase in the cost of capital will take some purchasers out of the market and potentially soften demand.  An additional $3,000 per month on a 10,000 SF building is equivalent to an extra $0.30/SF.

2.     Lower returns for investors needing financing

Using the same principle from the above example, buyers who finance their purchase will also not be able to pay the current premium in the market if their cost of capital increases 50%. Last year, we saw compressed cap rates for investment properties that sold – primarily from record low interest rates as well as government stimulus being injected into the economy. Going forward, interest rates are rising and government stimulus has been wound down.

Overall, a continued low supply of industrial properties on the market reduces the likelihood of a correction in the near term. Demand is still expected to remain strong until interest rates increase substantially. Our team is available to talk through the current market environment and put together a complimentary property valuation if that additional information would be of value to you. Feel free to reach out at any time, (858)-458-3361 or ajize@voitco.com