What 2021 Interest Rates Mean for Commercial Real Estate Investors

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All investors monitor the economy closely. Interest rates are just one indicator of an economy’s health. For residential real estate investors or buyers, low interest rates mean cheaper money and lower monthly payments. However, low interest rates for commercial real estate are a bit more complex. CRE investors and owners must consider multiple financial factors when determining the health of the market.

Interest Rates and Commercial Real Estate

Whenever interest rates rise or fall, it affects numerous sectors of the economy. Most businesses pay close attention to changes in the Federal Funds rate, also known as the Fed Rate. This percentage indicates the rate at which banks and other financial institutions lend money to one another. It’s a solid indicator of the overall health of the economy.

Moreover, CRE lenders and investors rely more on the 10-year treasury yield to determine financial stability. We’ll explain this more in detail below, but keep in mind that low residential mortgage rates do not always correlate to low interest rates for commercial real estate.

The Federal Reserve and Commercial Real Estate Rates

When the Federal Reserve (the nation’s central banking system) makes announcements about rate fluctuations, investors listen closely. These changes often reflect the nation’s economic health, and can therefore have a significant impact on interest rates for both residential and commercial real estate.

Throughout the Coronavirus pandemic, the Federal Reserve kept interest rates at historic lows, attempting to jumpstart a flailing economy.

The Federal Open Market Committee (FOMC) meets eight times a year to monitor the U.S. economy, and then decides to raise or lower to Fed Rate in response to economic performance.

July 2019 saw the highest Fed Rate we’ve seen in over a decade thanks to strong economic growth. By Q1 2020, those rates cooled somewhat ahead of the Coronavirus pandemic. However, once the pandemic hit our shores and the economic crisis began in earnest, the Fed Rate hit a freefall.

By the end of April, the Fed Rate was 0.04%, the lowest we have seen in decades. Those rates held steady throughout 2020 as the Fed attempted to jumpstart a flailing economy amid record-high unemployment.

How Lower Interest Rates Affect Commercial Real Estate

As the Fed Rate fell, so too did interest rates for commercial real estate lending.

Any person, business, or corporation who borrows money benefits from a stable Fed Rate. Specifically, for real estate investors, low interest rates often translate into increased investment opportunities. As the cost of borrowing money stays low or even decreases, investors tend to become more active, borrowing more money to take advantage of the overall financial savings. For example, an investor who previously passed on an opportunity to invest in an office building in Houston may reconsider that opportunity when interest rates are low. As a result, lower interest rates directly affect real estate sales, buoying them up as investors sink their cash into commercial properties. 

However, commercial real estate relies on more than just the Fed Rate. Investors must also consider the entire economic condition, local market conditions, treasury yield, and Cap rates. When the Fed Rate is at an all-time low, that’s generally an indication that the economy is struggling. As a result, investors must consider the potential risks of purchasing property in an economic downturn.

The 10-Year Treasury Yield

The Fed Rate isn’t the only determining factor for commercial real estate lenders. Unlike residential mortgages that rely heavily on the Fed Rate to determine their rates, commercial real estate relies heavily on the 10-year Treasury yield.

The 10-year Treasury yield is bonds paid back by the government as interest for borrowing money. When consumer confidence is high, fewer investors purchase these bonds, and the price for them drops. Therefore, the yield rate increases. 

On the flip side, when the economy is struggling, these bonds become increasingly popular because they are safe investments. As a result, the price increases, and the yield rate decreases. In short, a high yield rate indicates a strong economy and a favorable outlook. Low yields indicate economic uncertainty. In Q2 2020, the yield rate dropped significantly, but has remained relatively consistent through the rest of the year.

The Relationship Between Interest Rates and Cap Rates

It’s not only about low interest rates for commercial real estate investors. Other considerations factor into the decision-making process.

The capitalization rate, commonly called “Cap Rate,” is the expected return on an investment property. The Cap Rate is calculated by dividing the property’s net operating income (NOI) by the current market value.

As a mathematical formula, it looks like this:

Capitalization Rate = Net Operating Income / Current Market Value

Lower interest rates don’t necessarily produce favorable Cap Rates.

When interest rates rise, investors pay more to borrow money. Consequently, this drives up commercial property costs. Spending more to borrow money due to higher interest rates cuts into overall profits, therefore decreases the Cap Rate

Some investors fear rising interest rates could inflate Cap Rates, decrease property values, and consequently decrease returns. However, this is an oversimplification of the issue.

Typically, we believe the Cap Rate will deteriorate when interest rates increase. A commercial office building asset’s value may decline 5% for every .25% increase by the Federal Reserve. 

On the other hand, low interest rates for commercial real estate don’t necessarily produce favorable Cap Rates. The reality is that other factors affect cap rates as well.

Historically, interest rates aren’t the sole factor affecting commercial real estate performance. While there is a relationship between interest rates and Cap Rates, it isn’t as close as some might believe.

Therefore, the dramatic fall in the Fed Rate, combined with economic uncertainty due to a pandemic, has many investors nervous. While interest rates are favorable for borrowing, and prices have dropped exponentially, investors are wary of repeating mistakes made during 2008-2009.

What Can We Expect for CRE Interest Rates in 2021?

There’s no doubt the Coronavirus pandemic deeply impacted both the 10-year Treasury yield and the Fed Rate overall.

Recent findings indicate we may still have several quarters of reduced investor activity ahead. Though interest rates are low, lenders are exercising caution, making it harder for investors to secure CRE loans.

However, as we look ahead to 2021, there is reason to be hopeful. Not only have the 10-year yield and the Fed Rate stabilized in Q3 and Q4 2020, but they have shown signs of increase.

Recent findings indicate we may still have several quarters of reduced investor activity ahead. Though interest rates are low, lenders are exercising caution, making it harder for investors to secure CRE loans.

Other analysis predicts the U.S. GDP will be back to pre-COVID levels as soon as Q3 2021. If that’s the case, investors can expect to see positive impacts to the commercial real estate market. However, an economic rebound would also likely lead to a rise in the Fed Rate, and therefore rising interest rates as well.

If you want to stay up to date on the latest commercial real estate investment news, contact one of our investment brokers today. We can help you determine an investment strategy that meets your needs.

Shop Around for Low-Interest Commercial Real Estate Loans

Interest rates for commercial mortgages vary from lender to lender and from product to product. Since commercial real estate purchases require especially large loans, investors must shop around for the best rates.

Investors also have several different types of loans to choose between for their commercial real estate projects. Loans available to CRE investors include:

  • Conventional mortgages, 
  • SBA (Small Business Administration) loans, and 
  • USDA (United States Department of Agriculture) loans.

What’s more, there are also construction loans for ground-up developments and Fannie Mae Apartment Loans or Freddie Mac Apartment Loans for multifamily properties. 

Whatever loan you select, be sure to do your homework by comparing options so you find the best fit and the best rate for your investment.

Contact CXRE today for more information on investing in commercial real estate in Houston, Dallas, or San Antonio, Texas.

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