How Could Rising Rates Impact Commercial Real Estate?

A vacant commercial building with a for lease sign. This represents the effect of rising interest rates on the real estate market.

Despite the growth in telework, most businesses still require space for their employees to work. These buildings can come with a significant cost, whether they are purchased or leased.

Interest rates are one factor that can impact commercial real estate prices, and the Fed has raised rates aggressively in 2022 to combat persistently high inflation. As rates continue to climb, commercial real estate values are being affected, and that means business leaders should pay close attention to these markets to ensure they are prepared for changing prices.

The Current State of Commercial Real Estate

Right now, the commercial real estate market is strong. From the first quarter of 2021 to the first quarter of 2022, sales prices for office buildings rose 10%. During that same time period, retail spaces sold for 16% more, and prices for industrial properties climbed by 30%.

Vacancy rates are another important data point that business leaders should monitor, and they also indicate a strong commercial real estate market. For retail and industrial properties, vacancy rates are very low at just 4.5% and 4.1%, respectively. Additionally, for the three months ending in May, all commercial sectors experienced net positive absorption – meaning new square footage occupied exceeded square footage vacated. However, vacancy rates for office buildings remain elevated after the pandemic at 12%.

Rising Rates Could Have a Significant Impact on Commercial Real Estate

While the commercial real estate market is currently strong, rising interest rates could impact the industry in the following ways:

Higher Interest Rates Could Reduce Demand and Prices for Commercial Properties

When the Fed raises rates, their intention is to slow economic growth, and thereby, slow inflation. This works by increasing the cost of borrowing, making it more expensive for businesses to take out loans for large projects – like real estate. In general, higher costs reduce demand and that often leads to lower property values.

Higher Interest Rates Can Lead to Rising Rent

When property costs skyrocket, businesses often look to rent. This increased demand can put upward pressure on rental prices. In addition, property managers who are now paying more for their properties will need to increase rents to ensure the higher costs are covered.

In the short term, rents could continue to rise as demand for rental properties increases. However, if higher interest rates succeed in reducing inflation and curtailing demand, rents should stagnate or fall in response.

Rising Rates Can Lead to Defaults

High interest rates can make it difficult for property owners with adjustable-rate loans to meet their obligations. Additionally, higher rates can make it difficult to refinance loans. When property owners can’t lower their payments by refinancing at a lower rate, some may default.

Commercial Real Estate Outlook for 2022 and Beyond

As interest rates rise, expect demand for commercial real estate to fall, but this could take some time to materialize. Falling demand could lead to an overall weakening of the industry, which could bring lower property values, higher vacancy rates, and higher rates of default.

On the bright side, the commercial real estate market is currently very strong, with property values climbing, rents rising with inflation, and low vacancy rates. This means the industry may be able to withstand softening demand while avoiding some of its worst side effects.

At the American Deposit Management Co. [ADM], we help businesses react quickly to changing market conditions by providing valuable insights through our weekly articles. Follow us on TwitterFacebook, and LinkedIn to stay abreast of changes in interest rates, the economic environment, and the business landscape.

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