Both Interest rates and inflation can be expected to have an effect on commercial real estate investing for months and possibly years to come. With positive economic data spanning most of the country, the Federal Reserve announced back in December that it would back off from its bond-buying program. Ever since then, interest rates have slowly been climbing upward. Long term interest rates have risen from about 1% to about 3%. Average mortgage interest rates are now hovering in the mid 4% range.
Economic growth is forecast to be between 2.4% and 3.2 % for 2014. Economic growth is good for commercial real estate investors. Economic growth creates demand for commercial real estate. It increases occupancy rates and it leads to higher rents. Most of this will occur early in the cycle because new construction can take a year or more to catch up with demand. However, new construction will eventually fill the void that is about to occur.
The Impact of Rising Interest Rates on Commercial Investing
Rising interest rates by themselves don’t necessarily have a negative impact on all commercial real estate investing. However, it should impact the commercial sectors that you choose to invest in. Consider hotels, these are one day rentals that enable you to increase prices quickly as your costs increase with inflation or interest rates. Hotels can be a great hedge against inflation.
Next on the list are large apartment buildings. These typically have one-year leases. This gives you decent flexibility to raise rents as costs and interest rates go up. Since leases are scattered through out the year, you have the ability to increase income monthly, as different leases need to be renewed. The one negative about apartments is that theses were the first commercial real estate sector to recover from the economic melt down. They have been selling at high prices compared to market value lately and have little or no increased in value from appreciation for the next several years. However, apartment rents tend to track wages. If wages increase due to inflation, there could be substantial increase in rent income. Also, rising interest rates tend to dissuade residential home purchases that can lead to more renters driving lower vacancy rates.
The least flexible commercial leases are retail and manufacturing spaces. These are typically leased for five years or more. Longer term leases are more of an investing gamble when the economy is in fluctuation. If inflation takes off the way many experts are predicting, getting into a long term lease could be a bad investment. Unless you write a lease that increases annually based on the consumer price index or a similar inflation tracking index.
The Optimum Commercial Real Estate Investment
Ultimately, what you are looking for in this economic environment is strong positive cash flow that provides income along with property value appreciation as a hedge against inflation. A quality investment should shield against both rising interest rates and inflation. If you can include liquidity into the mix, all the better.
Real estate investment trusts (REIT) can be tempting at times like this but they have serious drawbacks. REITs are approximately 77% invested in triple net leases to investment quality leasers. The biggest drawback is these types of leases are typically for 10 years or more with no built in rent increases. These will provide reliable income but are not going to see any meaningful growth over the next few years. You’re not likely to overcome this type of fixed income investment when inflation takes hold of the economy.
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Author bio: Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years. He also draws upon 25 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest in the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.