The rumors are circulating that the Federal Reserve plans to end its quantitative-easing (QE) policy at the end of the year and scale back their long-term bond purchasing program at the end of 2013 which would lead to rising interest rates. This has been met by mixed reactions. The upside is that this can be seen as a sign of economic recovery, but there is still a lot of concern over the likelihood of rising interest rates and the impact that will have on the commercial real estate (CRE) mortgage market. Many investors in commercial real estate are concerned that these rumors are more than likely predictions that have a high likelihood of coming true.

What is QE?

QE is a policy shift by the Fed, during economic downturns, in which they switch from purchasing short-term government bonds to mortgage-backed securities and other assets with longer maturities. This results in increases in the prices of these assets and decreases in overall interest rates, which makes borrowing more affordable. Since November 2008, the Fed has initiated three rounds of QE. Round 1 resulted in the Fed holding $2.1 trillion in bank debt, mortgage-backed securities, and treasury notes by June 2010. During the second round, the Fed acquired another $600 billion in treasury securities by June 2011. September 2012 saw a new open-ended round of QE, which began as a $40 million/month mortgage-backed security purchasing plan but was increased to $85 million/month in December 2012. These rounds of QE have done exactly as intended by keeping interest rates low, but many are concerned that there will be rising interest rates when the Fed stops buying and starts selling their stockpile of long-term securities.

How Can Interest Rates Affect the CRE Prices?

There are myriad ways that interest rates can influence prices of CRE properties and mortgages. They include: capital flow; supply and demand for capital; and investor’s required rates of return on investment (ROI). As interest rates rise, the following situations can occur in the CRE market:

• Investors with floating-rate payments can end up with increased interest payments.
• There will be pressure to increase cap rates.
• Long-duration, low-yield and high-credit quality properties will become less desirable to investors.
• Investor interest in higher-risk, higher-yield properties is expected to accelerate.

Overall, an increase in interest rates is likely to result in an extension of the current landlord market as rental rates continue to rise and investors seek out opportunities with the potential to increase value to counter more expensive debt.

If interest rates start to move up, then cap rates will move up with them. What will this mean for values of commercial real estate?  The picture will not be pretty!  Today, cap rates on purchases of commercial real estate are now at an historical low.  If you are purchasing a Class A Office Building you will have to buy it at something like a 6 cap.  That means that for a “net operating income of $1,000,000 you will pay $16,666,666.  The seller of the office building will be a happy person.  Now, let’s assume that two years from now 10 year treasury bonds are not paying yields of 1.6% anymore.  Now 10 year T bonds are paying 4% which is closer to historic yields.  You, Mr. “smart investor” now want to sell your Class A Office Building which you purchased for $16,666,666 and retire to your scenic villa in Italy.  As you wisely foresaw, office rents have gone up roughly 5% per year, so your net operating income has now increased from $1,000,000 a year to $1,100,000 per year.  Good news for you.  But, wait a minute.  Interest rates have also gone up. Many analysts believe that cap rates will also go up with them. Many analysts disagree.  If cap rates do go up then Class A buildings may not sell at a 6 Cap any more but may sell for a 7.5 Cap, closer to their historic levels.   At a 7.5 cap rate, your Class A building with its $1,100,000 NOI is now worth $14,666,666!  You have just taken a $2,000,000 haircut.  Hopefully the Euro may drop in value so your ability to drink decent wine will lessen the pain.

This blog was written by Bob Amter, President of Montegra Capital Resources, LTD., a Colorado hard money lender.  [google_authorship] has been in the private capital lending business for 41 consecutive years.