Impact of interest rate hike on commercial RE

[Peter Goran]

We are new to the BP community and very impressed by it. We would be grateful to get the opinion of the community on the impact of interest rates on RE, especially given the current economic climate.

We are currently screening potential NNN commercial properties for purchase and would like to understand the impact of an interest rate hike. With mortgage interest rates at 3%, a 5% CAP rate is decent. If interest rates rise to 5%, a buyer would probably ask for a 7% CAP for the same property. Disregarding appreciation due to time passage, the CAP rate moving from 5% to 7% is going to bring the property valuation down by ~29%, unless of course one manages to increase the NOI. However, most leases last 10-15 years and have fixed increases (typically 10% every 5 years) that do not adjust based on interest rates or inflation. If in 5-10 years we want to sell we might have to do so at a low price to be competitive. If we refinance (typical commercial loans do not last more than 10 years) we may find that we are struggling to make mortgage payments for the new loan with the increased interest rate. So it seems that the buyer bears all the risk of rising interest rates. It also seems that in this scenario, the only way one could still profit is by having bought a property that is appreciating very fast. Do you agree with the above analysis, or is there something we are missing here? Any words of wisdom or thoughts on the above would be highly appreciated.