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.

[Mark H. Porter]

@Peter Goran Pete, I wouldn’t use the cap rate the way you are.  I use the cap rate simply to decide whether to even pursue a property further.

It’s one of my cut lines for qualifying properties.  For instance, my last NN STNL purchase started with me investigating properties of a certain asset class with a 6% cap.  Once there, I could subtract the debt service and capital improvement set-aside (note this was a NN) to determine my net cash flow.  

I’m not a big player in this game but earned, part-time, an early retirement with the ability to do pretty much anything I want.  Pay attention to net cash flow.