Interest rates are on the rise, a trend that is anticipated to continue through 2022 and well into 2023. In June 2022, the Federal Reserve, the nation’s central banking system, increased interest rates (for the second time in a row) by 75 basis points to a target range of 2.25% to 2.5%.
When the Federal Reserve announces rate fluctuations, investors should pay attention. These changes often reflect the nation’s economic health and can therefore have a significant impact on interest rates for commercial real estate (CRE). With inflation and interest rates at an all-time high, CRE investors must keep an eye on today’s aggressive rates and consider the potential effects on their returns. Investors with diversified investment portfolios that include commercial real estate will benefit from the industry’s ability to hedge against inflation.
Read ahead to learn about interest rate hedging in commercial real estate and how you can protect your assets in a continuously evolving (and unpredictable) market.
What Is Interest Rate Hedging and How Does It Relate to CRE?
Interest rate hedging is a means of reducing and controlling an investor’s exposure to risks in an ever changing market. Historically, commercial real estate is an asset used not only for portfolio diversification but also to hedge against inflation and minimize risks. Commercial real estate is often used for hedging because property values tend to increase along with inflation. Plus, property owners can increase rents to offset rising prices.
What Do Higher Interest Rates Mean for CRE Investors?
Nearly all commercial real estate is purchased using some combination of debt and equity. Therefore, rising interest rates can dramatically impact the cost of commercial properties. In short, as the cost of capital rises, it becomes more expensive to own and invest in real estate.
Amidst rising rates, some investors fear that capitalization rates and operational costs will rise while property values decrease. In turn, this could mean that properties will produce lower returns. Factor in increasing borrowing costs and higher vacancy rates, and the potential impacts of higher interest rates on investors are clear.
1) Higher Borrowing Costs
When interest rates are high, businesses are subject to higher borrowing costs. In turn, it eventually becomes more expensive for borrowers seeking CRE loans to construct, acquire, or refinance commercial property. Because of rising interest rates, it is also more expensive for banks to make large commercial loans. Consequently, borrowers may also encounter unfavorable terms due to higher loan costs. Thus, businesses seeking to expand or relocate potentially face challenges when attempting to secure financing for a commercial property. And with fewer transactions occurring, the outcome is often slower growth and fewer investments.
2) Higher Vacancy Rates and Increased Defaults
Rising interest rates can also lead to higher vacancy rates and decreased values of physical assets in commercial buildings. This low occupancy and risk for defaults may be attributed to tenants who may no longer be able to afford monthly rent payments. In today’s climate where 30% of renters have taken out a loan to help pay rent, landlords may have difficulty filling vacancies. In addition, high-interest rates can make it difficult for property owners to refinance their loans, leading to increased financial strain.
Ultimately, high-interest rates can significantly impact both new development and existing commercial properties. For investors, high vacancy rates signal a risky investment that is likely to negatively affect cash flow and return on investment.
How Can CRE Investors Hedge Against Rising Interest Rates?
For investors worried about how economic shifts will impact their portfolios, CRE investments can be a great hedge against the effects of inflation and rising interest rates. Below are specific methods CRE investors can take to hedge against rising interest rates:
1) Consider an Interest Rate Cap
An interest rate cap is a limit on how high an interest rate can rise on variable rate debt. A higher cap rate means that the market judges the property to have more risk, which means that investors need to earn a higher rate of return. For investors, an interest rate cap guarantees investment risks are at a minimum, even in a fluctuating market.
2) Consider an Interest Rate Swap
An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Interest rate swaps are one strategy CRE investors can use to establish reliable future cash flows regardless of future interest rate fluctuations. Because forward-thinking investors value risk mitigation (especially during uncertain times), interest rate swaps are a suitable means to minimize risks associated with macroeconomic conditions.
3) Speak With An Advisor
An advisor, like Thirty Capital Financial, can provide you with tools and custom solutions for interest rate risk management by using strategies that consider your risk tolerance and the current market. Whether it’s risk on current floating-rate debt, refinance risk on fixed-rate debt, or risk on prepayment penalties, an experienced advisor can help you manage the interest rate risk associated with that debt through consultations and strategic portfolio planning.
Ready to confidently manage financial risk, navigate shifts in the industry, and assess exposure for your CRE portfolio? Contact us today to speak with an interest rate hedging expert!