Over the past year, we’ve seen many stories about the impact of higher mortgage interest rates on residential real estate markets across the country. In one year, the average 30-year fixed-rate residential mortgage has gone from an all-time low of around 2.86% to over 7% today. The result has been a significant slowdown in residential real estate markets across the country. The National Association of Realtors reported that existing home sales are down more than 24% over the past 12 months, while new home sales are down 21% over the same period. Here in the Aspen-Snowmass area, we have seen a similar downturn in our residential real estate market, but there is still no evidence that values are declining.
At the same time, residential mortgage rates more than doubled, while commercial mortgage rates also increased significantly. In the summer of 2021, it was common to see mortgage rates on commercial properties quoted between 4.0% and 4.25%. Today, these rates are around 6% or more, an increase of more than 60% in one year. Since investment real estate is all about return on equity invested, an increase in the cost of money (i.e. interest rates) can have a much more profound impact on commercial real estate values. When it comes to commercial real estate investments, the leverage provided by borrowed money or mortgages is the lifeblood of the industry.
Most investment real estate is purchased with a commercial mortgage equal to 50% to 80% of the value of the asset, depending on the risk the investor or lender is willing to take. A combination of the mortgage interest rate, the loan to value ratio of the mortgage amount, and the investors’ hurdle rate for a return on investors’ equity determines the value of an investment property. If we use a reasonable return on investors’ equity of 12% annualized over the life of the investment, we can build a model of how the recent increase in commercial lending rates may have impacted the value of the most commercial real estate investments.
If you start with a base property that has a pre-determined net operating income (after expenses) based on the leases in place and a required return on equity for investors of around 12%, then you can isolate the impact that higher interest rates have on investment. real estate values. The first impact on value is an increase in the capitalization rate (cap rate) on purchase. A mortgage rate cap is like the interest rate on a bond. This is what the asset produces in return without leverage. As a general rule, the cap rate must be equal to or greater than the borrowing interest rate to produce positive leverage, meaning a higher return on equity than it would be without the use of leverage. leverage. The only time it might not be necessary is when the property is located in a market where rents have historically increased at a significantly above average rate – that’s how you might describe the history of a market like mall in downtown Aspen.
A year ago, when mortgage interest rates were at historic lows, an investor could achieve the desired annualized return of 12% by paying a lower cap rate at purchase and being able to obtain a higher loan amount compared to the purchase price. With commercial mortgage interest rates now 250 basis points higher (about 2.5%) and all other factors being the same, the model shows that an investor should buy this property at a value of 11% at 14 % lower than a year ago to achieve the same target return of 12% on their equity invested in the property. Higher interest rates mean the property must produce more income or be purchased at a lower price to produce the same return. In the world of real estate investing, an 11% to 14% downward shift is quite significant. When interest rates change dramatically in such a short time, it tends to dampen investment property transactions, as the gap between what sellers want to sell and what investors are willing to pay becomes too much. important for transactions to occur. .
As we look to the future, how is this interest rate environment likely to evolve? The Federal Reserve has made it clear in its last monthly meetings that it will continue to raise interest rates until the economy slows and inflation is shattered. Last week’s most recent inflation reading of 7.75% for October versus 8.2% for previous months may signal that inflation has peaked and may begin to decline. If inflation begins to decline, interest rates are likely to be near their peak as well. If so, the real estate investment environment could start to improve again.
Lori and William Small, CCIM are recognized experts in luxury and commercial real estate at Coldwell Banker Mason Morse in Aspen. They can be found on their website theSmallsaspen.com or by email at [email protected]