Over the last two years, interest rates headed in one direction: up. Back in January 2022, the Federal Funds Effective Rate was 0.08 percent. Fast-forward to year-end 2023, and the rate was 5.33 percent. The question is less about the “what” and more about the “why” and the “how.” Specifically, why are rates rising, and more importantly, how does this impact commercial real estate investing?
Why rising rates?
Interest rates have gone up because the Federal Reserve has been trying to curb inflation. Inflation sat at 8.2 percent in November of 2022, which was more than quadruple the Fed’s target of 2.0 percent. So far, the Fed’s strategy has worked. Consumer prices only went up a relatively mild 3.2 percent through October 2023, which is welcomed news for those waiting to see prices drop. However, higher interest rates can also bring good news for commercial real estate investment strategies.
Rising rates and purchasing opportunities
Rising interest rates can result in opportunities to purchase properties from distressed sellers— particularly those with variable interest rates. No one can foresee the future, so even prudent investors may have agreed to a variable rate and now find themselves unable to make their payments. Some property owners may be willing to part with their CRE asset for what they owe on their loan—or maybe even less—just to get it off their books. It may also be possible to find good deals in the foreclosure market as banks look to offload properties they’ve reclaimed. At the same time, rising interest rates also make it easier to get better deals in the traditional CRE market because there may be less competition.
Higher rates and negotiation opportunities
When interest rates rise, fewer people compete for commercial properties, which puts an investor in a better position when it’s time to negotiate prices. When interest rates were low, it cost much less to borrow money, which encouraged many buyers to make sizable offers on properties. Now that interest rates are higher, many of those investors are staying on the sidelines. Without several buyers vying for their property, sellers may be motivated to agree to a lower price. When in front of a motivated seller, a buyer has more power at the negotiating table.
CRE owners may be able to realize better-than-average returns due to higher rental rates during an inflation-driven economy. As is the case in the current economy, interest rates rose because inflation was on the way up. When inflation rises, it often takes rental prices along with it. For instance, while inflation peaked in the summer of 2022, rental rates in many sectors of CRE have continued to grow. For CRE owners, this could mean short-term gains that offset other assets that may have sub-par performances during inflationary periods.
While it’s impossible to tell for certain if or when interest rates will reverse course, those investing in commercial real estate can take advantage of the opportunities this presents. If investors have the financing they need, now may be a good time to purchase CRE assets, especially if they can find good deals in the distressed or foreclosure market. With fewer buyers throwing their hats in the ring, it may be possible to negotiate better deals and build a more robust CRE portfolio.
Josh Darby, vice president at Northmarq.
