What Higher Interest Rates and Inflation Mean for Commercial Real Estate

The Fed Is Set for Liftoff. How Will Cap Rates and Property Prices React?

Summary: Inflation and Interest Rate Impact on CRE

  • The heightened intensity, increased breadth and persistence of inflation have prompted a more hawkish pivot from the Federal Reserve. We now expect the Fed to begin to raise the federal funds rate at its March 15-16 meeting and to continue to gradually nudge rates higher over the next couple of years. The Fed is also expected to begin to reduce its $9 trillion balance sheet during the second half of the year.
  • The Fed’s moves will pull interest rates higher across the board but will also flatten the yield curve, particularly in light of the growing uncertainty resulting from Russia’s invasion of Ukraine.
  • Cap rates should follow interest rates higher but will not rise proportionally with long-term interest rates. At the onset of the pandemic, cap rates did not fall as quickly as interest rates did, meaning there is likely enough room for interest rates to rise without materially affecting cap rates.
  • Cap rates, however, do tend to move in the same direction as long-term interest rates. All-property cap rates generally have been on a downward slope over the past two decades, mirroring the trend decline of the 10-year Treasury yield.
  • The economic cycle and income-producing potential of any given property carries just as much weight as cap rates. A still-strong pace of growth is likely to support occupancy and keep rent growth firmly in positive territory, which in turn will bolster property income streams and valuations.
  • To that end, higher interest rates and more moderate economic growth may lead to cooler rent growth and property price appreciation in the years ahead.
  • There are sure to be some indirect effects of higher borrowing costs on CRE. Higher mortgage rates set the stage for continued erosion of single-family affordability, which is likely to boost multifamily fundamentals.
  • Despite higher interest rates, household balance sheets remain in solid shape, which should propel consumer spending in the years ahead. Stronger consumer spending will benefit retail, industrial and hotel properties.
  • High inflation, which has been the motivating force behind the Fed’s hawkish pivot, has also likely stoked investor demand for commercial properties. The ability to adjust rents has long made CRE an attractive inflation hedge. Persistently high construction costs and lengthier development timelines have bolstered property values.