The Impact of Increasing Rates on Investor Returns and Expectations

For the first time in three years, interest rates are on the rise. The Federal Reserve bumped up rates by 0.25% in mid-March, followed by another 0.5% rise in May, the largest increase in over two decades. For commercial real estate investors who are looking to capitalize on their property's present value, this uptick in rates has them keeping a close eye on the real estate market and how investors are playing the marketplace. Here are some of the ways that property owners can do what's best for their portfolios.

1. Rising Interest Rates and a Growing Economy

Despite concerns over inflation, the U.S economy is growing, and that is what has led the Fed to take comfort in delivering an interest rate increase. Investors are still watching the real estate market with a vested interest in particular metrics. One of those is the internal rate of return (IRR), a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

As mortgage rates rise, the effect on commercial real estate investing can be positive. Rental properties become a good investment as fewer people qualify for mortgages. However, rising interest rates do reduce prices, which can also lead to prospective homebuyers getting in on the rate before another surge in the numbers. As interest rates rise, fewer commercial real estate transactions will take place with tighter lending regulations. A 1% increase in the interest rate for an investor can turn into a positive value in overall profit for the portfolio.

2. A Little More About IRR

The ultimate goal of the internal rate of return is to identify the rate of discount, which makes the present value of the sum of the yearly nominal cash inflows equal to the initial net cash outlay for a commercial real estate investment. This is the best way to identify an expected return, recognizing the better investment among a range of properties. Using IRR is a way of identifying the rate of growth, similar to what's identified through the compound annual growth rate (CAGR). While the IRR will end up differing more often than not, it's the best and most popular metric for any given investment.

In most scenarios, the return will assume that any cash dividends are reinvested back into that commercial real estate property or the portfolio as a whole. IRR and other assumptions are important to keep track of complex cash flows. Finally, IRR is a calculation used for a commercial real estate book's money-weighted rate of return (MWRR). This will figure out the rate of return needed to start with the initial investment amount factoring in all of the changes, including sales proceeds. As a financial metric, IRR will assess the potential for total growth over time.

3. High IRR vs. Low IRR

High-interest rates are a good opportunity for commercial real estate investors across the U.S. to get in on a growing profit sector while the getting is good. When making an investment decision, a higher IRR means a higher return on that investment. In the world of commercial real estate, this high rate of return is associated with the average cost of capital. A steady internal rate of return is one that is higher than the initial amount that investors put into a project. A lower IRR, or negative rate, means that the cash flow received for the investment as a whole was less than the amount that was initially invested.  

Discovering the IRR function will pave the path to higher returns on the initial investment. There are other metrics to assess to truly understand that internal rate of return. The net present value (NPV) is important to know as these two values are closely associated. NPV is the difference between the market value of a piece of commercial real estate and the total cost of an investment. A positive NPV means you will see a profit, while a negative NPV means investors will be handed a loss. To calculate the NPV, you must determine what other properties are selling for to assess market values in the area. Essentially, it's the interest rate that would make the market value and total cost equal to zero. 

4. Benefits of Investing in Commercial Real Estate with Higher Rates

A healthy economy can be a mixed bag in the long term for commercial real estate investors, but there are positives to locking in properties for your portfolio while interest rates are on the rise. Multifamily properties, for example, are highly resilient to high lending rates because of low housing availability and high occupancy. This increase in demand boosts the climate for renters, paving the way for high occupancy rates for investors based on that percentage increase in tenants and renters. This should compel a startup or commercial real estate investor to embrace what would translate into a positive cash flow for the long term.

This increased demand also translates to rent increases that are within reason. This is common practice in big cities and urban markets to realize optimal cap rates that boost net operating income (NOI). The practice of acquiring undervalued properties and renovating them has become popular with multifamily investors. Buyers in this market are able to lock in competitive lending rates for improvements to transform their portfolio until the completion of the renovations.

If you are opting to enter the commercial real estate investment world, you also should be aware of the tax benefits resulting from operational enhancement and capital improvements. Depreciation on real property is one of the biggest deductions for a commercial real estate investor. Deductions are taken from the NOI related to the property value as well as assets within those units. This helps investors ease the burden of incrementally rising interest rates. It's important for commercial real estate investors to consider the assets of financial planning. Inspecting budgets and investments in regular intervals is crucial to positive cash flow, which in turn leads to tenant satisfaction, turnaround on investments, and a brighter future for the commercial real estate portfolio.