Small: How higher interest rates impact investment real estate | Opinion







Small

Over the past year, we’ve seen many stories of how higher mortgage interest rates are impacting the residential real estate markets across the country. In a year, the average 30-year, fixed-rate residential mortgage has gone from a historic low of about 2.86% to over 7% today. The result has been a significant slowing of residential real estate markets across the country. The National Association of Realtors has reported that existing-home sales have declined over 24% in the past 12 months, while new-home sales are off 21% in the same period. Here in the Aspen-Snowmass area, we’ve seen a similar slowdown in our residential real estate market — but no evidence yet that values are declining.

At the same time residential mortgage rates have more than doubled, commercial mortgage rates have also increased substantially. In the summer of 2021, it was common to see mortgage rates on commercial properties quoted between 4.0% and 4.25%. Today, those rates are in the 6%-plus range, a more-than 60% increase in a year. Because investment real estate is all about return on equity invested, an increase in the cost of money (i.e. interest rates) can have a much more profound impact on commercial real estate values. When it comes to commercial investment real estate, leverage provided by borrowed money or mortgages is the lifeblood of the industry.

Most investment real estate is purchased with a commercial mortgage loan equal to anywhere from 50% to 80% to the value of the asset, depending upon how much risk the investor or lender is willing to take. A mix of the mortgage interest rate, the loan-to-value ratio of the mortgage amount and the investors’ hurdle rate for a return on the investors’ equity determines what an investment property is worth. If we use a reasonable return on investors’ equity of 12% annualized over the term of the investment, we can create a model on how the recent increase in commercial lending rates may have impacted the value of most commercial investment real estate.

If you start with a baseline property that has a predetermined net operating income (after expenses) based on leases in place and a required equity return to the investors of about 12%, then you can isolate the impact that higher interest rates are having on investment real estate values. The first impact on value is an increase in the capitalization rate (cap rate) at purchase. A real estate cap rate is like the interest rate on a bond. It is what the asset produces in return without leverage. Typically, the cap rate has to be at or above the borrowing interest rate to produce positive leverage, meaning a return on equity that is greater than it would be without the use of leverage. The only time this might not be necessary is when the property is located in a market where rents have historically increased at a significantly higher rate than average — which is how you could describe the history of a market like the downtown Aspen commercial core.

A year ago, when mortgage interest rates were at historically low levels, an investor could achieve their desired 12% annualized return by paying a lower cap rate upon purchase and being able to obtain a higher loan amount relative to the purchase price. With commercial mortgage interest rates now 250 basis points higher (approximately 2.5%) and all other factors being the same, the model shows that an investor would have to purchase that property at a value anywhere from 11% to 14% below a year ago to achieve the same 12% target return on their equity capital invested in the property. Higher interest rates mean the property needs to produce more income or be purchased at a lower price to produce the same return. In the world of real estate investing, a shift of 11% to 14% to the downside is pretty significant. When interest rates change this dramatically in such a short period of time, it tends to apply the brakes to ­investment real estate transactions, as the gap between what sellers want to sell for and what investors are willing to pay grows too large to make transactions happen.

As we look into the future, how is this interest rate environment likely to change? The Federal Reserve has made it clear in its last few monthly meetings that it will continue to increase interest rates until the economy slows and the back of ­inflation is broken. The most recent inflation reading last week of 7.75% for October versus 8.2% for the previous months may signal that inflation has peaked and may start to decline. If inflation is starting to decline, it’s likely interest rates may be near their peak as well. If that turns out to be the case, the environment for investment real estate could start to improve again.

Lori and William Small, CCIM are recognized luxury and commercial real estate experts with Coldwell Banker Mason Morse in Aspen. They can be found through their website theSmallsaspen.com or by email at thesmalls@theSmallsaspen.com.

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