Interest Rate Risk: Key Factors Real Estate Investors Need to Know

One of the key reasons for diversifying into commercial real estate is its ability to generate recurring income and capital growth. This can allow investors to offset the slowdown in other asset classes like housing. When evaluating a commercial property, however, interest rate risk is a key factor to consider. This is especially crucial in the present scenario of interest rate escalations.

Monitoring interest rate risk is an ongoing process. However, the benefits are well worth the effort. This blog looks at the impact of interest rate changes on commercial real estate.

How Interest Rate Risk Impacts Commercial Real Estate Investments

Commercial property prices have a strong correlation with long-term interest rates. In turn, interest rates influence cap rates, a key variable for commercial real estate investors looking to acquire properties. A cap rate is a metric used to calculate the profitability of a property. It is arrived at by dividing net operating income by its price.

Generally, an increase in cap rates means a reduction in asset value. On the other hand, when cap rates decline, prices increase. This is because cap rates go up when interest rates rise. For investors, rising rates impact future cash flows resulting in lower asset values. However, several other factors determine the movement of commercial property values. For example, a property with stable NOI can be profitable despite interest rate fluctuations.

In addition, the short-term impact of cap rate changes is more profound.  Over the long term, its impact is limited.

Factors That Drive Interest Rates

Rising prices lead to a contraction in demand and reduces the purchasing power of consumers. Moreover, businesses are forced to increase wages to keep pace with the increased cost of living, which only fuels inflation.  Over the past few months, the Fed has been aggressively increasing interest rates to cool the economy.

For the foreseeable future, interest rates are expected to remain high to reduce the supply of money in the economy. Other factors responsible for interest rate fluctuations include increased bond yields. 

We’re here to help

Interest rate risk can be mitigated by proper due diligence and risk analyses. Most private investors often need access to the right resources to do this. Working with an experienced financial advisor or wealth manager can help bridge this gap and allow you to make strategic decisions. True North has been working with investors for over 30 years to provide unbiased, objective investment solutions that build and preserve wealth long-term. 

For more information, contact our team today!