Interest Rates and Commercial Real Estate
Commercial real estate interest rates can greatly impact returns for any deal. The higher the interest rate, the more a buyer will have to pay for the debt each month, which can greatly impact your bottom line.
It's helpful to understand how commercial real estate interest rates impact the debt market. By understanding the market and being aware of interest rates, you can make more informed decisions about your real estate investments and the quality of deals an operator offers.
But how are interest rates impacting the market?
What loan options do operators have for commercial real estate?
How can operators hedge this risk?
In this blog, we'll explore each of these questions.
How Interest Rates Impact Commercial Real Estate Investments
The current interest rate environment is causing investors to scrutinize each deal more than they have in the past. This change in scrutinization is due to the fact that interest rates are higher than we've seen in the recent past, and investors are not sure how long this will last. As a result, deal flow has slowed down across the entire real estate market.
Today, real estate investors and operators can't simply go out and buy a property and hope that it's going to appreciate as it has in recent years. Operators need to purchase properties based on current interest rates and have realistic expectations about all other expenses while underwriting deals. This fact is especially true if refinancing the property is a part of the business plan.
Higher interest rates also mean that operators need to have additional scrutiny when underwriting all aspects of the deal. There simply isn’t as much room for error as there has been in the last several years that had such great market velocity (or incredible appreciation).
Commercial real estate owners need to execute on all levels of their operations, including:
Tracking the financial statements
Commercial property owners who are not able to operate their properties efficiently and are impacted by rising interest rates will be at a greater risk.
This change in the current market is why it's so important for investors to do their homework when selecting an operator to invest alongside in this environment. By taking the time to understand the debt market and the deal they're looking to invest in, they can make a well-informed decision that's more likely to result in a positive return on investment (ROI).
Fixed Rates vs. Assumable Loans
When you're investing in a commercial real estate deal, one of the most impactful assumptions is how a property is financed. Currently, commercial real estate investors look for two primary financing options: a fixed-rate mortgage or a loan assumption. Both have their pros and cons, so it can be difficult to decide which financing option is best for a specific property. Let's take a look at the differences between fixed rates and loan assumptions below so that you can understand how financing can impact your investment as a passive investor.
Fixed rates are exactly what they sound like. Your interest rate will be locked in for the life of the loan, so you'll never have to worry about that rate increasing. This type of mortgage can be a great option if you're worried about interest rates going up in the future. It also gives you peace of mind knowing that your monthly payments will stay the same for the life of the loan.
Fixed rates aren’t always the right option, though. They often come with longer terms (7 to 10-year loans, for example). If the property is sold earlier than the full term or refinanced for a lower rate, a hefty fee may be required. If these fees are not integrated into underwriting from the beginning, they could be a significant blow to investors’ cash flow.
Loan assumptions, on the other hand, are loans that pass from the seller to the buyer. A buyer “assumes” the loan terms from their seller in this case. The buyer becomes fully responsible for the seller’s loan from that point on, and the original borrower (seller) is no longer liable.
It's crucial to note that a loan assumption is not the same as a refinance when it comes to the debt market—the new borrower is not getting a new loan. They're simply assuming the payments on an existing loan.
Assumable loans can be hard to find. They also can come with big fees. Operators must incorporate associated fees, a longer close time, and other criteria into the underwriting for these types of loans.
Which Choice Is Right for You?
So, how does this impact you as a passive investor? It depends on your investing preferences. If you're worried about interest rates going up in the future, then investing in a deal with a fixed-rate mortgage may be a better option. Be sure to ask the operators if there are any additional fees or criteria for a fixed-rate mortgage. You will want to see that they are integrating those numbers into the underwriting of the deal.
If you want to invest in a deal with a lower interest rate, then a loan assumption may be a better choice. For example, with current rates being in the 5 to 6 percent range, you could potentially assume a loan that was negotiated with a 4 percent interest rate. Again, look for any additional fees or penalties for this type of debt when you review the investment offering.
For many commercial property investors, assuming loans has become a popular strategy with a lot of new deals. Operators may find that paying the extra fees and waiting the additional closing time to assume a loan from the seller is worth it. They are looking for projects where they can assume debt that's potentially at a better rate. What this means for a passive investor is that there may be better cash flow in a syndication with an assumed loan than one that has a higher interest rate. That isn’t always the case, however, and an investor should always ask about the consequences of any different loan structure.
How To Hedge Your Risk
Commercial real estate hedging strategies are important for a few reasons. First, the debt market for commercial real estate is often cyclical, meaning rates and rent tend to go up and down. Additionally, the cost of commercial real estate can be high, so investors want to make sure they protect their investments.
There are a few different ways to hedge your risk when investing in commercial real estate that we'll cover below.
Invest in Fixed-Rate Mortgages
Many investors consider a fixed-rate mortgage to be the key to a successful real estate investment during periods of higher interest rates. A fixed-rate mortgage offers stability and predictability. You know exactly what your monthly payments will be for the duration of the loan, which makes budgeting and planning much easier.
Even if interest rates rise in the future, you'll be protected against increases with a fixed-rate mortgage. This protection can be especially important if you're planning to hold your property for a long-term investment.
When it comes to hedging your risk, if you can get a fixed rate, that's the ultimate hedge.
Buy a Cap on Floating-Rate Mortgages
The other option for hedging your risk is investing in a deal that incorporates debt with floating rates where you buy what's called a cap. A cap means that the rate can only go up to a certain amount.
However, buying the cap requires that investment groups pay a fee upfront, which is generally a percentage of the total investment. The cap, then, acts as a form of insurance against interest rate hikes within the debt market.
The reason this can be a smart move is that when you're investing in a property, you're not just betting on the current interest rate environment; you're also betting on where interest rates will be in the future. And if you think interest rates are going to go up in the future, it might make sense to buy a cap.
Of course, there's no guarantee that interest rates will go up or down. But if you think there's a good chance they'll go up, buying a cap can be a way to protect yourself against that risk. Talk to your operator to learn more about caps and how they may impact any deal you’re evaluating.
Investing in Commercial Real Estate
As you can see, interest rates have a significant impact on the current syndication deals operators can offer. The current deal flow is slowing down, and many operators are looking into fixed-rate mortgages and loan assumptions for the best rates. Furthermore, seeking a fixed rate or buying a cap on floating-rate mortgages are some of the ways these operators are looking to hedge this risk. So, consider the current market conditions we've covered, and always ask your operator to explain any assumptions with current debt structures.
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