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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2013

Higher Rates, Bigger Decisions

Help clients understand investment dynamics when interest rates increase

Mixed reactions have dominated the months following the Federal Reserve System’s indication of a possible end of its quantitative-easing policy later this year. There has been positive sentiment that the economy is recovering, but there also have been concerns about what impact the likely increase in interest rates could have on the commercial mortgage market.

To prepare for this impact, commercial mortgage brokers should develop realistic perceptions of the current investment-property market, as well as its likely reaction to higher rates. Generally, investors have become more confident in the stability of the market, despite the challenges that have continued in the aftermath of several turbulent years. Now, things may be changing with the anticipated increase in interest rates.

Interest rates drive property prices in a variety of ways: They affect capital flows, supply and demand for capital, and investors’ required rates of return on investment. When interest rates increase, many investors with floating-rate payments will have to make higher interest payments. That can raise questions regarding these investors’ credit risk, but it still ultimately goes back to the impact on individual or company goals. Many may agree that now is the time to lock in long-term debt before rates increase further.

Because there has been a flight to high-credit quality properties in the past few years, capitalization rates have been suppressed significantly for these assets. As interest rates increase, it will put upward pressure on cap rates. Although it is unlikely to see a drastic increase in interest rates, there will be a correction to normal levels. Perhaps the largest negative impact will be seen in long-duration, low-yielding and high-credit quality properties. The more you navigate out of that environment, the less impact you will encounter.

In addition, keeping lease terms shorter and looking at some investment properties with opportunities to add value may be a good opportunistic strategy. Expect an increased appetite from investors seeking higher-risk, higher-yield investments going forward. It is evident that the market is going through a phase of recovery and landlords will not have as much fear of lease expirations when properties are at or below market rents — and rental rates are on the rise.

In short, if your clients have a property like a pharmacy, with 10 years or more remaining on the term, now would be the time to sell. If your clients intend to buy a property like a shopping center, with a potential to add value with debt, there may be no better time to go ahead and pull the trigger.

There are several reasons for investor clients to stick with low-yielding investment properties, which can help them reduce the overall volatility in a diversified portfolio. The most important thing for investors is to be appropriately allocated for their risk appetite and yield goals.

For developers and lenders of long-duration, low-yielding and high-credit quality properties, it will be paramount to underwrite deals with a more conservative cap rate to guard against the interest-rate correction. Because each portfolio and property is unique, commercial mortgage brokers should provide clients with much-needed advice on what to expect from lenders. 


 


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