Commercial Real Estate Is Facing a Triple Threat: Interest Rates, Inflation, and Recession
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Loading... - Haniah Hagan
- 29 Sep 2022
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Commercial property sectors, other than office, have recovered well after the shock of the pandemic. Generational demographics and a particularly robust job market have sustained demand, and rents and occupancy are continuing to rise, albeit at a slower pace than last year. The fundamentals are good, yet property investors are appropriately nervous. They face the triple threat of higher interest rates, higher inflation, and a high probability of recession, each of which will impact the performance of their real estate investments in different ways. As we mentioned in our commercial real estate mid-year review, these external factors are already slowing down transactions and impacting asset values, despite the otherwise superb performance of the properties themselves.
This is the first of a series of articles and webcasts addressing the changing real estate investment and operating environment driven by economic factors rather than supply and demand. Looking forward, investors in both equity and debt will be assessing the impact of these new dynamics on property cash flows and investment returns. Market participants will also be carefully watching whether the abundant capital available for commercial real estate for more than a decade will begin to recede as other investment alternatives provide more attractive risk-adjusted returns. Part of that equation is the relative weight of each of the triple threats to the industry; for example, will real estate’s role as an inflation hedge win out over the impact of higher costs of capital? These dynamics, currently unpredictable, will reveal themselves over the coming months.
Interest Rates
As we noted in our mid-year review, interest rates to real estate are like fire to a scarecrow, and therefore the most potentially damaging of the triple threats. Owners with near-term debt maturities and investors looking to develop or acquire properties must reassess their deal economics as both rate indices and credit spreads widen. Lower yields and the uncertainty of the interest rate environment at the exit is causing investors to pause and rethink their strategies. Moreover, lenders are increasingly skittish about the impact on the debt service coverage ratio if debt service grows faster than net operating income. Less cash flow cushion and the potential for lower collateral value has already reduced the availability of debt capital, at least in the short-term. On a positive note, many loans with longer maturities, say seven-to-ten years, may be maturing in an interest rate environment similar to that when the loan was originated. As always, the impact is property by property, market by market.
During the past decade of artificially low interest rates and abundant capital, the spread between interest rates and capitalization rates has been remarkably wide, leading many to predict that there will be enough room for interest rates to grow without impacting cap rates. However, during the last few months of volatility and uncertainty we have already seen a measurable pick up in cap rates in selected markets and property types. As interest rates find their new equilibrium so will cap rates; commercial real estate performance and valuation will always remain cyclical. But the impact will be highly differentiated by the varying demand for space in particular markets.
Inflation
Inflation will have a direct impact on property construction and operating costs, as the market has already experienced since early this year. Some higher costs have been driven by supply chain disruptions that have begun to moderate and will continue to seek equilibrium. However, some expenses are likely to remain high for the foreseeable future. Wages and benefits, in particular, appear to have reached a new plateau given an incredibly robust job market and ubiquitous worker shortages. Utilities are also likely to remain high due to geopolitical forces and more unpredictable and severe climate in many parts of the country. Climate change is also driving up the cost of property insurance. Read More...
