Rising Interest Rates Are Creating Turbulence in the CRE Investment Market

Capital costs are rising, but fundamentals remain strong and real estate is also benefiting as a hedge against inflation.

After a long run of incredibly cheap capital, the commercial real estate industry is adjusting to a big jump in the cost of debt. In some cases, loan rates that were quoted around 3 percent six months ago are now in the mid to high 4s. Yet just how impactful those higher financing costs will be on deal flow, pricing and investment strategy remains to be seen.

Real estate investors agree that higher capital costs are putting upward pressure on cap rates, and there likely will be some near-term choppiness in the transaction market as both sellers and buyers adjust pricing expectations. At the same time, the market has to account for some counter forces, including strong fundamentals and a still sizable amount of dry powder. In particular, there is “high velocity” capital from closed-end funds that have deadlines to place capital that has already been raised.

Last week, the Federal Reserve raised the federal funds borrowing rate by another 50 basis points. The increase follows a 25-basis-point bump in March, which was the first rate increase since 2018. Although Fed rate increases are more closely correlated to short-term floating debt, many in the real estate industry also have been watching big moves in the long-term rate benchmarks.

The 10-year treasury yield has climbed sharply, rising about 140 basis points since early March to hover around 3.1 percent as of May 6. Layering on top of higher interest rates, many lenders have widened their spreads by 20 to 30 basis points to account for higher inflationary risk. The result is that loan rates being quoted by lenders are now 150 to 200 basis points higher than they were in first quarter.

One window into current financing rates is BBB or Baa corporate bonds that trade most closely with low leverage, long-term fixed-rate CRE debt. Those bond rates bottomed out around 2.22 percent in September of 2021, and as of early May were trading around 4.69 percent—a roughly 240 basis point increase