Written by: Chase Agin
Chase Agin is a student at Ohio Wesleyan University studying Finance Economics with a minor in Accounting. He interned with Colliers | Columbus this summer on the Research team, helping with special projects. Keep reading to get Chase’s take on interest rates in the commercial real estate sector.
Interest rates are widely used as one of the main economic indicators for the health of an economy, but they also can become confusing given the numerous rates that exist and how they are differentiated. They are often associated with real estate, on both a residential and commercial level. Interest rates generally reflect the current health of the economy and are set by the Federal Reserve. These rates are set based on what the Federal Reserve believes to be current state of the economy—if the economy is doing well, the rates will likely increase and if the economy is doing poorly, they often look to lower them. The rates offered to borrowers can also vary based on the amount of risk involved. These rates directly affect what happens in the residential real estate market, but their impact in the commercial side can vary on other components of the market.
The commercial real estate market does not squarely relate to the interest rates as there are many other factors that play a role in whether people see it as fit for investment. Commercial real estate can seem like an attractive investment when interest rates are low because of how cheap it is to borrow money, however this usually means that there is economic uncertainty. This uncertainty results in the increase of the risk of an investment and where there is increased risk, the expected return must reflect that risk. This is not always the case, though, and is where there can be a slowdown in the commercial market. So, along with rates, risk plays a major role in the CRE market.
As previously mentioned, the expected return and the perceived risk go together when it comes to investments in the commercial real estate space. Investors also must consider what is going on in the market. For this, investors will generally look at the capitalization rate (or “cap” rate) to see if there is a high premium to own commercial property. The cap rate is defined as the operating income divided by the purchase price of the property. This metric tells how long it will take for an investor to be able to retrieve their initial investment. The cap rate is used as a metric of risk versus return, and for many investors this can outweigh the pros or cons that come with high/low interest rates.
Although interest rates and cap rates are not directly correlated, there is a slight relationship between the two. When interest rates are low, businesses are encouraged to expand, and commercial real estate becomes more in demand. Commercial real estate then becomes more expensive and drives down the cap rates. So, there is some correlation as interest rates fall so should the cap rates. In contrary, when interest rates are raised, the demand for commercial real estate lowers because of less expansion and in turn raises cap rates because of the increased risks associated with owning a property.
Even though interest rates are associated with real estate in general, the role they play in the commercial real estate market is quite complicated and differs from the residential side. Investors look at a wholistic picture before deciding to make an investment, rather than focusing on just the interest rates. This wholistic picture includes weighing the risks associated with the property as well as the potential return that can be earned. Interest rates can play a role in an investment decision, but investors are generally more concerned with other factors. Now more than ever it is important for investors to be conscious of the interest rate environment and the possibility of it changing in the future.