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  • Writer's pictureRick Martin

The Impact of Interest Rates on Commercial Real Estate Investments




In today's real estate market, higher interest rates prompt investors to closely analyze each deal, signaling a shift from previous practices. Uncertain about the duration of these elevated rates, investors are adjusting their expectations and experiencing a slowdown in deal flow throughout the industry.


Real estate investors and operators can no longer rely solely on property appreciation. To ensure prudent decision-making, operators must align property purchases with prevailing interest rates and have realistic expectations regarding other expenses during deal underwriting. This is especially crucial when refinancing is part of the business plan.


The Importance of Scrutiny in Deal Underwriting during High-Interest Rate Periods


Elevated interest rates necessitate increased scrutiny in evaluating all aspects of a deal. The market's previous leniency for errors, given its remarkable appreciation and velocity, is diminishing. Commercial real estate owners must effectively execute various operational levels, including asset management, property management, financial statement tracking, and leasing rates. Failure to operate properties efficiently amidst rising interest rates puts owners at a higher risk.


Investor Due Diligence in Selecting Operators and Understanding Debt Market


Given the changing market dynamics, investors must diligently research and select operators to partner with in the current environment. Comprehensive understanding of the debt market and the specific investment deal is crucial for making well-informed decisions that maximize the potential for a positive return on investment (ROI).


Comparing Fixed-Rate Mortgages and Assumable Loans in Commercial Real Estate Investing


When investing in commercial real estate, the financing method significantly impacts the investment outcome. Presently, investors primarily consider two financing options: fixed-rate mortgages and loan assumptions. Understanding the differences between these options is vital for passive investors to comprehend how financing choices can affect their investments.


Fixed-Rate Mortgages: Stability and Considerations


Fixed-rate mortgages provide a locked-in interest rate for the loan's duration, offering stability and protection against future rate increases. While this type of mortgage is suitable for those concerned about rising interest rates, investors should be aware of potential penalties if the property is sold or refinanced before the full term. The rate also tends to be higher.


Assumable Loans: Opportunities and Factors to Consider


Assumable loans allow buyers to assume the existing loan terms from the seller, transferring full responsibility to the buyer. Although this option offers opportunities, finding assumable loans can be challenging and may involve significant fees. Operators must carefully incorporate associated costs, extended closing times, and other criteria into their underwriting process for these loans. While tapping into lower rates from the past sounds favorable, the process can be cumbersome.


Investing in Commercial Real Estate: Choosing the Right Option and Hedging Risk


As a passive investor, your decision depends on your investing preferences and concerns about future interest rate fluctuations. To mitigate risks, it's important to assess which option aligns with your goals. If you're wary of increasing interest rates, investing in a deal with a fixed-rate mortgage might be preferable. 


However, it's essential to inquire about any additional fees or criteria associated with fixed-rate mortgages and ensure that operators incorporate those figures into the deal's underwriting process. Alternatively, if you seek lower interest rates, opting for a loan assumption could be more suitable. For instance, with current rates ranging between 5% and 6%, assuming a loan negotiated at a 4% interest rate might be advantageous. When reviewing investment offerings, it's crucial to identify any potential fees or penalties related to this type of debt.


The Popularity of Loan Assumptions and Their Impact on Cash Flow


Many commercial property investors have embraced loan assumptions as a favored strategy for new deals. Operators often find it worthwhile to pay extra fees and endure longer closing times to assume a loan from the seller, particularly if they can secure debt at a favorable rate. For passive investors, this could mean improved cash flow in a syndication involving an assumed loan compared to one with a higher interest rate. However, it's important to note that this isn't always the case, and investors should inquire about the consequences of different loan structures.


Effective Strategies to Hedge Your Risk in Commercial Real Estate


Implementing hedging strategies in commercial real estate is crucial for protecting investments, given the cyclical nature of the debt market and the substantial costs associated with commercial properties. Here are a few ways to hedge your risk:


  1. Invest in Fixed-Rate Mortgages: During periods of higher interest rates, many investors consider fixed-rate mortgages as a key to successful real estate investments. The stability and predictability offered by fixed-rate mortgages allow for easier budgeting and planning, as monthly payments remain consistent throughout the loan duration. By securing a fixed rate, you're safeguarded against potential future interest rate increases, which is particularly advantageous for long-term property investments.

  2. Purchase Caps on Floating-Rate Mortgages: Another risk hedging option involves investing in deals that incorporate debt with floating rates and buying caps. A cap limits the interest rate increase to a predetermined level. However, purchasing a cap entails an upfront fee, typically a percentage of the total investment, acting as insurance against interest rate hikes within the debt market. This approach acknowledges that real estate investments are not solely influenced by current interest rate environments but also by future interest rate projections. If you anticipate a rise in interest rates, buying a cap can protect you from that risk, but as the year has proven, the costs for these replacement caps can skyrocket. In some cases it can require an infusion of capital, which is not ideal. 


Understanding the Impact of Interest Rates on Commercial Real Estate



Interest rates play a significant role in the current landscape of syndication deals offered by operators. As interest rates rise, deal flow is slowing down, prompting many operators to explore fixed-rate mortgages and loan assumptions to secure favorable rates. To hedge risks, operators are opting for fixed rates (some are still  purchasing caps on floating-rate mortgages, which has proved challenging). It's crucial to consider the discussed market conditions and always communicate with your operator to gain clarity on assumptions related to current debt structures.



 

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