How High Interest Rates Impact Commercial Real Estate

Interest rates have eased recently, but borrowing rates remain higher than they have been in about two decades. The Bank of Canada (BoC) and other central banks were quick to raise interest rates as part of their inflation-fighting crusade. However, the flight down may not be as swift, especially if renewed inflationary pressures return to the forefront for businesses and consumers. As a result, a common concern that companies, investors, and the broader real estate sector have is how much high interest rates impact the commercial real estate market.

What is typically forgotten in the interest-rate conversation is that monetary policy functions with a lag.

So, for example, the central bank’s rate hikes from early last year are only now being felt in the wider economy. The five percent policy rate environment could still take a few more months until it is enacted in the marketplace.

But why does this matter to the commercial real estate industry? There are many ways that higher interest rates affect the sector altogether, which can then weigh on the broader economy.

Less Investment

One consequence of higher interest rates is that it results in less capital expenditure investment. Indeed, investors will pay a higher cost because borrowing is more expensive. Therefore, investors might not be as excited about paying higher prices for commercial real estate assets, leading to a decline in valuations.

A rising-rate ecosystem will generally force a substantial portion of investors to rethink their strategies. As investment costs balloon, there is typically a cascading effect: shrinking sales, slower leasing activity, and a drop in demand for new development projects.

This year, the one thing that has been apparent is how much slower the economy becomes when the Bank of Canada pulls the trigger on a series of rate hikes. While Canada averted a recession, monthly GDP growth rates of zero percent or 0.1 per cent are not exactly an endorsement of a robust and resilient economic landscape.

Tighter Credit Conditions

An uptick in interest rates creates a tighter credit environment, meaning that it is harder for investors, developers, and other vital market participants to qualify for loans. In a credit-dependent economy, this can initiate a period of slower economic growth.

Even as inflation eases, running companies becomes a taxing endeavour as costs mount on every front. One area businesses may choose to trim the fat by reducing their overhead costs could be their commercial real estate expenses, leading to an exit to smaller venues.

Of course, it cannot be forgotten that consumers might see a reduction in disposable income and will choose to trim their spending, eating away at companies’ bottom lines.

Threats to the Banking System

Like south of the border, a high-rate ecosystem and slower commercial real estate market could pose risks to some of the nation’s top lenders, according to a report by the Office of the Superintendent of Financial Institutions (OSFI).

Last fall, Canada’s chief banking regulator sounded the alarm on how much the “shift in the risk environment” has become a titanic-sized event for the financial system.

In the area of the commercial real estate market, the OSFI report noted that commercial properties are usually vulnerable to the central bank raising interest rates. However, recent developments, particularly in the office sector and construction and development segments, could pose significant risks to financial institutions.

“Construction markets show signs of a slowdown. Office CRE valuations have come under pressure as the industry grapples with rising vacancies,” the OSFI document stated, adding that recent ratings downgrades on commercial establishments are falling short of adjustments to the risk ecosystem.

Looking ahead, the OSFI noted that banks “should expect further engagement” in these segments and will partner with these entities to garner additional data on valuation revisions and ratings.

While offices account for a smaller percentage of banks’ loan portfolios, it was enough of an issue that banks identified growing credit risk in the commercial real estate market in their third-quarter earnings reports and calls this past summer.

The Globe and Mail reported in October:

“Royal Bank of Canada’s provisions for credit losses – the money that banks set aside for loans that could default – were boosted by large provisions for financings in the office and multifamily segments. Canadian Imperial Bank of Commerce booked impairments in its U.S. office space portfolio, and the bank said that it is lowering its exposure to the segment.”

Better Risk Management Practices

Ultimately, the commercial real estate sector will need to engage in better risk management to navigate the turbulent waters facilitated by rising interest rates. This might consist of meticulous analyses of property fundamentals or enhanced examinations of market conditions to assist in the quest to find better investments or even improve upon current ones. This can be a balancing act as you want to maximize returns but also make sound financial decisions.

It is a blatant example of a risk-reward conflict, something that has been absent in the years-long world of historically low interest rates.

A Better Year Ahead for Commercial Real Estate?

Surging borrowing costs and sliding commercial property prices definitely affected Canada’s commercial real estate sector in 2023. However, in the year ahead, many experts anticipate a complete turnaround, particularly if the economy averts a downturn and interest rates do come down.

Industry leaders say that debt markets are stabilizing and offering less debt, meaning that everyone is assessing equity and searching for better returns. And real estate, from residential to commercial, is undoubtedly an exceptional way to tap into sublime equity opportunities.

“People feel that they’re not at the top anymore looking over a cliff, but perhaps at the bottom, looking up. Investors feel like it’s a good time to start making investments,” Adam Spies, co-head of US capital markets at Newmark Group Inc, told BNN Bloomberg.

Many observers say commercial real estate is one of the most attractive markets in both Canada and the rest of the world. The data show there is growing demand, inventories are subdued, prices are mixed, and interest rates are coming down. This is a perfect storm of opportunity.