Higher Interest Rates & Lower Property Value: How Investors Can Best Navigate this Market

As we close out 2022 and look ahead to the new year, real estate remains a hot topic. Over the past two years, we saw mass migration from cities to suburbs as lockdowns sent workers home and millennials largely reached points in their lives where home ownership became a priority. We saw housing prices skyrocket as interest rates dropped to historic lows. And now, as interest rates continue to climb again, investors and traditional home buyers alike aren’t quite sure what to do.

Our job is to give you the tools you need to make the investments and other financial decisions that best serve your goals. So, to help you make sense of the current real estate market, we’re breaking down how these recent interest rate hikes will likely play out and what that means for you as an investor.

4 Consecutive Federal Reserve Interest Rate Hikes of 75 Basis Points

First, let’s define basis points.

A basis point is one hundredth of a percent. One basis point is written as 0.01%.

10 basis points, often abbreviated as bps, is written 0.10%.

100 bps is written as 1.00%.

In 2022, the Federal Reserve raised its interest rate by 0.75% on four separate occasions. As of December 14, 2022, the federal interest rate is 4.25-4.50%. The federal interest rate is the rate that commercial banks can charge each other to borrow excess reserves overnight.

How Does the Federal Reserve Rate Affect Commercial Mortgage Rates?

So, what does this mean for the market—and for you? To put it bluntly, it makes commercial loans more expensive. When an increased federal rate makes it more expensive for banks to borrow money needed for commercial loans, the banks pass that increase onto borrowers. Debt service cost, which is the cost of borrowing money, and the interest and principal payments due on a loan during a specific period of time—go up for both parties.

When things cost more, you buy less. And that’s exactly what’s happening in the market now. Commercial real estate transactions slowed down dramatically in the third quarter of 2022.

How to Navigate this Cycle in the Market if you are a Real Estate Investor

As a real estate investor, determining the best strategy for navigating this next phase of the market cycle can be tricky. Keep in mind that with a lower loan-to-value ratio on the loans you take out, you’ll get a lower leveraged internal rate of return. That doesn’t necessarily mean you should sit this cycle out, but that you might need to change up your investing strategy for your next commercial real estate purchase.

It’s always in your best interest to discuss your specific financial status, needs and goals with a professional advisor so you can receive personalized advice. However, here are a few general guidelines to follow as an investor in the current real estate climate:

  • Raise more common equity capital than you did previously. It’s the amount of money all common shareholders invest in a company, and in this climate, it’s prudent to build yourself a capital “buffer”.
  • Similarly, raise more preferred equity capital than you did for previous investments. This is the capital that certain investors put up in exchange for certain perks, like a higher rate of return than common shareholders.
  • Raise your mezzanine debt. This is the debt that’s subordinate to pure debt, but senior to pure equity. In other words, it’s the debt that your lender can convert into equity in your company in the event you default on your loan.
  • Hustle more! Deals are more difficult to find, and when you do find them, they’re often more difficult to execute than they were in the past. The only way to counter this is to spend a lot more time and effort looking for deals. This might mean trying new avenues for finding deals or simply devoting more time to researching them.

As a prospective buyer, effective due diligence is more important now than it’s ever been. This is because the market is more competitive, and deals are closing faster than they did in previous years. Compounding this, lots of sellers are keeping their prices high and aren’t willing to negotiate down very far because they saw how much their properties were worth just six months ago.

As an investor, you know what’s going on in the real estate market… but that doesn’t mean the seller always does. When a seller doesn’t understand how interest rate increases can decrease property values, it can be difficult to get on the same page and negotiate effectively. That puts the onus on you to do watertight due diligence and when possible, arrive with cash in hand. Buyers with more cash and a solid understanding of a property’s value are more competitive and tend to close their deals more quickly.

What Do the Next Few Years Look Like?

Here’s what the experts are predicting will happen over the next few years: the commercial real estate market will grow. In fact, the economists surveyed for the ULI Real Estate Economic Forecast are largely predicting better-than-average growth in a variety of sectors over the next few years. These include GDP growth, unemployment rates and CMBS issuance. They also forecasted the commercial real estate transaction volume to moderate somewhat from its 2021 level but remain higher than it was pre-pandemic.

For inflation, the economists predicted 6% in 2022, 3% in 2023 and 2.5% in 2024.

So what does this all mean for your investing strategy? It could mean a pivot. Or a shift. Or perhaps a slowdown or refocusing. It doesn’t mean real estate’s a poor investment—in nearly all economic climates, real estate is generally one of the most profitable investments you can make. But how you invest in real estate can change depending on a variety of factors, and a skilled financial expert in the industry can help you determine your best strategy based on these factors.

Contact Sax’s Real Estate Team

We can’t predict every little detail or exactly when things will happen in the market, but here’s what we can do: use all available data to assess the current market, forecast the changes and trends these current conditions will cause, and advise you on how to optimize your portfolio and capitalize on these trends. If you’re a real estate investor or you want to learn more about investing in real estate, speak with a member of our real estate team.


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