The Fed raised its benchmark interest rate from zero to 0.25 percent In December of last year. It was the first increase since the Great Recession in 2008. Experts initially expected hiking the rate as many as four more times this year, but lowered their expectations as economic trouble overseas (first in China, then in Britain) rocked the global economy.
Last fall, the Fed signaled that its December 2015 meeting was a likely time for a rate hike when it included the phrase “next meeting” in its statement. Many expected a similar comment this year from the Fed statement, but the phrase wasn’t there. Although the central bank’s top officials voted to keep rates unchanged during their two day policy meeting in Washington, experts say the Fed appears on course for a December hike, if financial conditions and the economy are strong enough.
How Interest Rate Increases Affect CRE
Access to capital – Access to capital is one of the main drivers of any real estate deal whether it’s acquisition or a new development. Higher interest rates mean that borrowers have to pay more in interest than they would if they had borrowed the same amount of money before the rate hike. In the short term, these higher rates may cause concern about future rate hikes and could drive borrowers to seek refinancing now, before rates rise again. Higher interest rates have the potential to constrain property deals as they can become an obstacle for borrowers who have to pay more to access money for loans or mortgages.
Cost of capital – This could leads to borrowers paying more interest to lenders. However, it could also lead borrowers to get smaller loans in the first place if they calculate that they would not be able to keep up with interest payments on a larger loan. This forces them to either put up more equity or target lower priced property. Riskier loans like construction loans and riskier assets may be harder to finance because of the added risk premiums.
It’s important to point out that higher capital costs could also increase default risks. These could be bad for lenders, too. And if these defaults continue to spread, it could prove detrimental to the economy as a whole.
Lending institutions could tighten loan standards – Knowing that higher interest rates eat away at borrower net incomes and property values, lenders could respond by tightening lending standards or loan collateralization. They could limit lending in a risky market or reduce the loan to value ratio. That would require a greater amount of money up front before issuing a loan. They might also require more collateral to back up their loans.
Property valuations – The huge amounts of cheap debt floating around the market may have stimulated property values. While an extended period of increasingly expensive debt, may cause valuations to crumble.
Although raising interest rates will undoubtedly affect the commercial real estate market, it’s not all bad news. Higher interest rates may actually signal a stronger economy. The fact that the Fed wants to raise interest rates means its economists consider the economy to be in good shape, and a healthy economy is a benefit to the commercial real estate market. If a growing economy becomes inflated, it can lead to higher rental prices and higher sale prices.
The impact of the Fed’s change in the future could be to lower risk in the commercial real estate economy and avoid another burst bubble like the one that rocked the economy in 2008. The more conservative atmosphere and tighter lending requirements can make it harder to get a loan. This means that higher interest rates give lenders and borrowers an incentive to minimize risk which can reduce the likelihood of another bubble.
The Gray Area
So will these rate hikes be likely to be good or bad for commercial real estate? Unfortunately, the answer is not black and white. It’s also important to remember that as of now, interest rates remain low. But ultimately, we can expect rate hikes to leads to a more conservative and less risky lending environment, for better and for worse. As a result of higher interest rates, lenders will need to manage their risk better and become more selective as to which properties they’re willing to finance.
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