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Inflation and Rising Interest Rates

By
Commercial Real Estate Agent with Sperry Van Ness

Inflation and Rising Interest Rates
By Miguel de Arcos - While we are currently in the throws of a severe recession and are experiencing a historically low interest rate environment, these times won't last forever. In fact, I have received numerous questions of late from commercial real estate investors wondering about the likelihood of rising inflation and an increase in interest rates in the future. In the text that follows I'll share a few thoughts on inflation and interest rates as they apply to commercial real estate investments so that you can plan accordingly...

The reason for the up-tick in conversation surrounding the topics of inflation and rising interest rates is simple; inflationary times cause a spike in interest rates which has a direct impact on the state of capital markets supply and pricing. This in turn also has a direct ,and often severe impact on the overall commercial real estate market. So, it's time to answer the questions at hand: Will we see inflation as we come out of the recession? I believe so. Will interest rates rise in the future? Most certainly...Now that I've answered the questions, I'll explain my rationale in the text that follows.

It is important to understand that as economies recover from recessionary periods and capital supply increases that inflation often rears its head. Think about this...according to the Federal Reserve Board, money supply in the US has increased nearly three-fold in the last five months. During this same time period consumer spending, capital investment, and virtually any other measure of investment (other than government spending) has declined sharply. So, where is all the money? Much of it is parked on the sidelines waiting for safer and more stable times to return. While I don't see economic recovery in the near term, it will eventually happen. When it does and the money starts to work its way back into the system, I believe we'll see a sharp rise in inflation and interest rates.

However, if there is any good news to take away from this it is as follows: it is important to note that we are presently in a unique market which is being heavily influenced by a severely constrained capital and credit market. In fact, many of the market characteristics typically caused in an inflationary market (which I'll describe below) are being experienced in today's low interest rate environment...just for different reasons. What I'm trying to convey here is that while the market is likely going to get worse before it gets better, we are experiencing much of the pain earlier in the cycle than is normal. The net effect of this is that the markets are already well into the weeding-out process, causing consolidations to occur now that typically wouldn't take place until later in the cycle.

As a baseline for a deeper analysis, it is useful to have a macro-economic understanding of what happens to asset level supply and demand drivers, and the resultant impact on Net Operating Income (NOI) in a rising interest rate environment. As a general economic principle, when inflation occurs and interest rates rise, the cost of new construction increases thereby slowing the number of construction starts and depleting new supply of product coming online. This scenario in turn causes an increase in overall market absorption rates and creates a "landlords market" environment. The market dynamics which favors the landlord creates an opportunity for property owners to increase rents, thereby allowing NOI growth to keep pace with any escalation in interest rates. While this scenario is favorable to existing property owners, making the rise in interest rates less of a concern to owners of existing assets, the impact to developers and tenants is clearly detrimental, and can have a negative overall impact on the economy if a high interest rate environment lasts for any length of time. At a more micro-level, some of the major issues surrounding the impact of increasing interest rates on commercial real estate are addressed below:

Flow of Funds: In a typical low interest rate environment (note: the current market is certainly not typical) commercial real estate provides a reasonable investment alternative to other low yielding asset classes. However, with rising interest rates the supply-side availability of capital marked for commercial real estate will constrict. The aforementioned contraction will be due to a combination of reduced demand for new supply as weaker developers are weeded-out of the market, and alternative investment opportunities in other asset classes begin providing a better yield while being perceived to have less risk when contrasted with commercial real estate investments.
Cost of Funds: The overall blended cost of capital will increase dramatically during an inflationary period. This increase will come not only as a result of rising interest rates across underlying indices, but moreover, as a result of lower advance rates in the senior debt position, which will shift a higher percentage of the capital structure up in the leverage curve. This reduction in LTV and LTC advance rates will cause a borrower to rely more heavily on mezzanine and equity financing resulting in a higher cost of capital to borrowers (mote: we are experiencing some of the same issues in today's market, but for different reasons).
Investment Sales: Sales of investment grade properties will slow rapidly as many of the buyers that typically exist in low interest rate environments will move to the sidelines. Default rates will climb and more distressed property will come onto the market as investors who leveraged-up on floating rate debt during the low interest rate environment will have a hard time keeping control of property as their debt service obligations increase.
The bottom line is this...Since capital is already constrained and the cost of funds is low, buyers should take advantage of bargain shopping now by looking to acquire low leverage, value added investment opportunities. I would specifically look for assets with upside potential for NOI growth through improved management and upside pop in leasing opportunities.

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Comments (1)

Matt Heisler
Heisler & Mattson Properties - Southborough, MA
Real Estate & Investor Services

Sound reasoning.  I would just add that I expect rents to drop, or vacancies to rise, in many markets.  It will affect the NOI.

Mar 23, 2009 01:38 PM