Commercial real estate is a popular alternative investment strategy, especially with investors familiar with the evolving market. But choosing the right property is just part of the equation.
In addition to arranging the financing for a commercial real estate investment purchase, owners and managers will need strategies to keep profitability at an acceptable level when interest rates are rising.
A commercial property that features both retail and office space may be a prime pick in today’s changing business environment.
Commercial property loans are mortgages specifically assigned to purchasers of commercial real estate properties. While there are some similarities to residential purchase loans, there are additional options for CRE investors. Depending on the current economy, rising rates may affect commercial real estate (CRE) investors’ profitability.
If you’re new to CRE investing, this article will provide you with several strategies for managing CRE loans when interest rates are rising. First, let’s review the basics of commercial real estate investments. Then, we’ll move on to management strategies in an inflationary economic environment.
CRE Investing Basics
If this is your first foray into CRE investing, these rules will apply to most of your future transactions.
- A property is considered commercial if they produce income within a business scenario. Commercial real estate can be a retail space, office space or a building containing several of these spaces.
- While investors may qualify for more than one CRE financing program, they should always be prepared to guarantee the mortgage with collateral.
- Generally, CRE loan terms are for 5 to 20 years, with a separate amortization period that is longer than the loan’s duration.
- In addition, CRE loans have some similarities to residential mortgages, although there are some major differences.
Understanding and staying familiar with these basics will form a solid foundation for your decision-making.
Commercial vs. Residential Loans
As a homeowner, you might be thinking that a commercial loan process will be similar to a residential mortgage. While some loan guidelines are similar, there are major differences.
- CRE loans are designed to finance income-producing properties that rent space to businesses. For this reason, individuals rarely qualify for these loans.
- Commercial loans are usually granted to business entities. Developers, trusts, funds, and corporations tend to be the most common recipients of these loans.
- While credit worthiness is required for both residential and CRE loans, commercial lenders’ underwriters will examine the property’s potential income production when deciding whether to approve a loan request.
Now that we’ve covered the basics of CRE loans, it’s time to focus on how rising interest rates may affect these investments.
Commercial real estate buildings that offer open-plan options are increasingly popular with companies planning to bring remote workers back to the office.
Rates, Inflation, and Commercial Real Estate Investments
Even though inflation is typically painful for consumers — with the prices of just about everything rising faster than wages — these pain points don’t always transfer to CRE investors. However, you may be nervous about 2022 inflation figures and the possibility of a future recession, especially if you remember the lingering 1980s recession.
But there are major differences between today’s and yesterday’s high interest rate environments and some good news for today’s CRE investors.
- Even though inflation rose rapidly during the first half of 2022, unemployment numbers remained at near-historic lows. During the 1980s recession, unemployment topped 10%.
- 2022’s economic climate is distorted by supply chain disruptions and increased energy and labor costs. However, these were created by the COVID pandemic, which is slowing due to improved vaccines and milder variants.
- Rising labor costs and supply chain issues are limiting new construction development, which benefits owners of CRE properties.
Low unemployment and building material shortages are two reasons CRE investments thrive in rising interest rate environments. Here’s one more.
Locating Real Estate for Today’s Workforce
Recent research has found that, although there has been a major shift towards home offices and remote workers, the demand for commercial office space is strong.
- As more companies summon workers back to the office and new office lease agreements are being signed, their property managers are being tasked to find not just any office: they need offices that reward and retain staff.
- Recent research supports the need for modern, collaborative workspace, with 90% of today’s professionals putting more value on their work experience than their compensation.
- Your task? Focus on finding real estate that offers, or is ready for, your new tenants to add amenities and technology that will create the ideal work environments.
Open floor plans, standing desk options and plenty of sunlight can help create the work environments in demand by today’s young professionals.
In addition to making the right CRE investment choices based on your future tenants, there are other ways to minimize reductions to profitability due to rising interest rates.
Minimizing Costs Before and After Purchase
While CRE investments offer a hedge against rising rates, owners and managers still need to follow these guidelines to retain acceptable profit margins.
- Before compiling a shortlist of possible purchases, have each one inspected by an inspector and/or engineer you choose and hire.
- While your lender will probably have the building appraised for underwriting purposes, it’s essential that you know exactly what you’re buying. If an inspection turns up any problems, negotiate repairs before signing on the dotted line.
- Opt for shorter-term leases. Here’s why: even though inflation rarely rises as quickly as in the first half of 2022, there is constantly a chance rates could rise faster than your tenants’ lease periods.
Do your research, stay diligent, and happy investing.