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Commercial Property Insider

The Ugly Truth About Interest Rates

5 Minute Read

The harsh reality is that rising interest rates can significantly diminish the value of your commercial real estate and reduce your net worth. 

This is applicable even if you don’t have a mortgage, because if you are looking to sell, you are often dependent on purchasers who require financing.

Would understanding how interest rates could have such an impact on your net worth help you? If so, read on.  

How Interest Rates Are Determined

Controlling interest rates is one of the main methods used by the Bank of Canada (BoC) to stabilize the economy and manage inflation.

The BoC’s policy rate, also known as the benchmark or overnight rate, directly influences banks’ prime rates and the interest charged for loans and mortgages. 

High interest rates raise the cost of borrowing, which can dampen the economy as a result of a decline in corporate and consumer expenditure, a decrease in business investment, or a reduction in confidence as expenses increase. Rising rates can also increase the debt service cost associated with alternative financing, such as lines of credit and other short-term funding.

It can also reduce the demand for commercial real estate as the cost of capital becomes more expensive, where the costs may be greater than the returns or benefits of property ownership. 

Low interest rates lower the cost of borrowing, which can stimulate the economy by increasing corporate and consumer spending, increasing business investment by reducing operational and expansion costs, or increasing confidence as expenses become more manageable. Low interest rates can also decrease the costs associated with alternative financing, such as lines of credit and other short-term funding.

It can also increase demand for commercial real estate, as the potential returns or benefits from investing in a property or properties may now outweigh the cost of capital.

Bottom line: Bank of Canada interest rates can have a significant impact on businesses that use leverage, affecting cash flow, business confidence, and commercial real estate values. In a high-interest rate environment, the value of your property may go down as buyer demand decreases due to a reduced level of debt service affordability, a higher down payment requirement, or an increase in capitalization rates, along with an increased perceived risk of the commercial real estate market.

Understanding the reasons for a change in interest rates is critical

There is a strong (though not exact) correlation between the direction and magnitude of the change in interest and capitalization rates, particularly for investment properties with tenants and those valued using an income valuation.

Borrowers bear the increased lending costs due to higher benchmark or overnight Bank of Canada rates. Market participants will demand a higher return and capitalization rate the higher the cost of capital.

As cap rates rise, there will be negative pressure on a property’s value due to the following formula: 

Value = Net Operating Income/Capitalization Rate 

An increase in perceived risk and capitalization rates exerts downward pressure on commercial real estate values. This leads to the perception that an increase in interest rates is detrimental. It is therefore important to understand the underlying reasons for a change in interest rates.

Strong market fundamentals are causing an increase in interest rates

An increase in interest rates could actually be positive due to healthy underlying economic fundamentals and positive momentum. For investment properties, this may eventually lead to an increase in net rents due to successful business. 

Lease renewals will reveal the increases in net operating income. An increase in rent can occur in the short term for commercial property types like multifamily, but it often occurs in the mid- to long-term for other property types like industrial real estate. 

In a strong economy, the net operating income and valuation of an income property may actually increase despite an increase in interest rates, as the rental income may outpace the increase in expenses. 

Weak market fundamentals are causing a decrease in interest rates

Alternatively, if interest rates rise because of a stalling economy, a decrease in bank funding, or an increase in credit demand, these are negative factors for property valuations. 

Refinancing risk also increases with rising interest rates

With high interest rates, there is also the potential for a cash call, as debt servicing ratios may be out of balance as required by a lender.

For example, at the end of a 5-year fixed term and at the time of a mortgage renewal or refinancing, additional capital is required in order to maintain debt servicing levels. If a property owner does not have the additional capital available, they may need to sell part or all of the property.

If a building owner does have the funds available in order to qualify for financing under a revised interest rate environment, they must determine if the return on equity will make sense to continue to hold the property and invest that additional capital in the asset.

Bottom line: Interest rates can have a positive or negative impact on commercial property values, depending on the economy’s core strength and the root cause of interest rate increases.

The impact on commercial real estate activity and values is significant

High interest rates

When interest rates are high (or there is a forecast for a hike in interest rates), property owners can experience a reduced ability to manage the debt servicing costs on their mortgage. Concurrently, the number of people who are willing and able to make a large down payment, or who can handle a larger monthly mortgage payment to qualify for a revised standard of financing can also decrease.
This can reduce the number of buyers and market demand. As the demand for spaces decreases, the corresponding sale price may also decrease, leading to a decrease in the number of willing sellers or the supply. (See our article, Who Wants to Understand the Real Estate Market? for more information.) These factors, in aggregate, often reduce a commercial property’s market value.

Low interest rates

A low-interest-rate environment stimulates the real estate market as more buyers enter the market to take advantage of favourable financing. This increase in demand typically leads to an increase in prices. As the prices rise, the number of sellers who are willing to sell also rises, thereby increasing the supply.  (See our article, Who Wants to Understand the Real Estate Market? for more information.) These factors, in aggregate, often increase a commercial property’s market value.

NOTE: Low interest rates for extended periods of time can be indicative of failed economic and fiscal policies. A low interest rate environment can overinflate property values and, over long periods of time, cause asset bubbles, which lead to a high level of volatility in the market.

Bottom line: Interest rates impact property values through the economic fundamentals of supply and demand. These fluctuations in aggregate give rise to the commercial real estate market cycle.

Conclusion

Are you a property owner aiming to reduce the impact of interest rates on your commercial real estate transactions?

Through our proprietary research and a dedication to our clients to help improve their financial security, if you are in the Edmonton market, we’d like the opportunity to sit down to review your specific circumstances. 

We will provide our Value Preservation Workbook: The Ugly Truth About Interest Rates, which shares strategies that can help you achieve peace of mind and outperform the market, even in high-interest rate environments. Contact us today to learn more.

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Coming soon: If you are outside of the Edmonton market, this resource will be available for purchase on our website, get in touch today to find out details. 

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