The Effect of Interest Rates on Commercial Real Estate

Interest rates are extremely important in the evaluation and performance of any commercial real estate investment due to their impact on the present value of future cash flows.

What causes interest rates to fluctuate?
Interest rates can fluctuate due to changes in supply and demand, inflation and the movements of the Federal Reserve.

Here is how each factor affects interest rates:

  • Supply and Demand:
    • An increase in the supply of credit will cause lower interest rates.
    • A decrease in the supply of credit will cause higher interest rates.
    • An increase in the demand for credit will raise interest rates.
    • A decrease in the demand of credit will lower interest rates.
  • Inflation:
    • When inflation occurs, interest rates tend to rise in the long-term. This happens because lenders will mandate higher rates in order to protect themselves from the lower purchasing power of money when they are repaid in the future.
  • The Federal Reserve: 
    • The Federal Reserve can influence interest rates by two means: by raising or lowering the discount rate, or by indirectly influencing the direction of the Federal funds rate.
      • The discount rate is the interest rate charged to banks when they borrow funds overnight from The Federal Reserve Bank. When a bank's cost of money increases, they pass this increase along to their customers. This makes capital more expensive, which leads to a decrease in borrowing.
      • The Federal funds rate is the interest rate charged to banks when they borrow overnight funds from other banks. When this rate is adjusted, it can impact the rates banks charge to consumers on all types of loans. When the Federal funds rate rises, the cost to borrow money goes up.

How do fluctuating interest rates impact the value of commercial real estate?
When interest rates rise, the future cash-flow value of a property decreases; however inflation can increase the value of a property since real estate is itself a hard asset. A hard asset is a commodity with a limited supply and therefore an inherent value as it serves a basic human need.

If the increase in property value from inflation outweighs the decrease caused by rising interest rates, the net result of the investment can be positive. Due to this increase in property value from inflation, real estate is often one of the most popular types of investments during times of rising interest rates.

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