How Rising Interest Rates Impact Commercial Real Estate Investing

In recent months, the Bank of England has continued to raise interest rates after years of keeping them at historic lows. There is no doubt that dept options are not as favourable as they were 12-18 months ago.

Focusing specifically on commercial real estate, below are some of the reasons why increased interest rates my have an impact:?

1. Debt financing becomes too expensive?

When interest rates go up, the cost of borrowing becomes more expensive. In simple terms, let’s imagine you have a ￡10m loan with an interest rate of 5%. If that interest rate increases by 1%, then your annual interest payment will increase by ￡100k – that is 20% more than what it was before the increase.

This will lead to some property owners going into default on their loans or having less cash to spend on other things such as business development.

2. Debt financing becomes detrimental to returns?

Rising interest rates result in lower returns on a property as the expenses for holding that property have increased. Previously, debt would often be beneficial to returns as borrowing was cheap and allowed you to do more with your capital. Now, the cost of borrowing is so high, that debt is no longer accretive to returns. Difficult decisions are having to be made around whether the benefit of being able to spread your capital is worth the reduction in return on that capital.

3. Commercial property prices decrease?

When debt becomes more expensive, demand for real estate declines and prices decrease. Sometimes this can be because other investments, such as bonds, become more attractive, or it could be that investors simply cannot afford to pay the prices they were previously willing to pay. This is because either they cannot get debt on their investment, or the impact of debt is detrimental.

This provides some investors with a great opportunity to purchase real estate at low prices, but at the expense of other investors.

4. Slowdown in economic growth?

As businesses have to pay higher borrowing costs, running businesses becomes more expensive, prices increase, inflation grows, and consumers have less disposable income to spend with these businesses. Coupled with the recent change to working habits from COVID-19, businesses will try to save money where possible, potentially reducing their overhead costs by reducing their use of commercial real estate.

In light of all of the above, it is really important that all angles of a property investment are considered before making an investment decision. Cost of capital and returns should be analysed before making an investment decision. Cost of capital and returns should be analysed in financial models and the fundamentals of real estate itself, such as age, location etc should be properly considered. Diversification of a real estate portfolio across different asset classes and locations can also help mitigate some of the risks posed by rising interest rates.