As interest rates rise, so has the cost of doing business in commercial real estate. At the same time, average yields on commercial properties have been dropping, and so the narrowing spread between the two metrics is putting the CRE industry in a pinch.
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Until recently, demand for commercial properties has been robust and buoyed by the strong economy. As a result, the common reaction to higher interest rates in the commercial property industry has been a shrug.
But now, according to data firm Trepp, the gap between long-term borrowing rates and average yields for some commercial asset types is contracting. That divide has not been this narrow since 2008, the Wall Street Journal reports.
The rise in borrowing costs for real estate has come as the U.S. prime rate has crept upwards in recent years, from 2% in 2013 to 5.25% now.
Currently, the average lending rate for CRE deals is just a shade over 5%, with average property yields at 6.45%. Property yields have largely been going down since 2012, when they were about 7.5%, according to Trepp. At the same time, lending rates have bounced between 4.5% and 5%.
The impact of higher interest rates is having a rippling effect in the commercial real estate sector. As interest rates go up, CRE appraisals start to reflect lower valuations, Entrepreneur reports, because higher interest rates tend to cut into earnings. Lower potential earnings equate with lower valuations.
As property values drop, owners may find their mortgages tougher to renew or refinance.
For their part, commercial property investors are factoring interest-rate risk into their calculations, as they have been since the interest-rate lows of the early 2010s.
According to Deloitte's 2019 Commercial Real Estate Outlook, interest rate risk is one of the top three areas of concern for CRE investors, along with geographic risk and tenant risk.
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