Interest Rates and Commercial Real Estate: What Investors Should Watch in the Current Market

Few factors have a greater influence on commercial real estate than interest rates. After years of historically inexpensive capital, the CRE industry has adjusted to a significantly different financing environment—one where borrowing costs are higher, underwriting is more conservative, and investors are placing greater emphasis on current cash flow and disciplined acquisitions.

The relationship between interest rates and commercial real estate is relatively straightforward. As borrowing costs rise, the cost of financing an acquisition increases, reducing the amount of debt a property can support. This can place downward pressure on property values, particularly when sellers remain anchored to pricing established during periods of lower interest rates.

However, the relationship is not always immediate. Commercial real estate values often take time to adjust because transactions are less frequent than in public markets. When interest rates rise quickly, a gap can develop between buyer and seller expectations. Buyers underwrite based on today's cost of capital, while sellers may continue to expect yesterday's valuations. This disconnect has been one of the primary factors contributing to lower CRE transaction volume in recent years.

Why Interest Rates Matter for Property Values

Higher interest rates affect more than monthly debt payments. They can influence capitalization rates, debt-service coverage requirements, loan proceeds, investor return expectations, and ultimately the price a buyer is willing to pay.

When investors can earn higher returns from lower-risk alternatives such as government bonds, commercial real estate must offer a sufficiently attractive risk-adjusted return to compete for capital. This can contribute to upward pressure on cap rates and downward pressure on property values.

The effect varies considerably by asset class, location, property quality, and income growth. Properties with strong rent growth, durable tenant demand, and the ability to increase net operating income may be better positioned to offset higher financing costs. Conversely, assets with declining occupancy, significant capital needs, or limited income growth can face greater valuation pressure.

Refinancing Remains a Major Challenge

Perhaps the most significant consequence of elevated interest rates is the impact on existing owners with maturing debt. Many properties were financed when rates were considerably lower and property values were higher. As those loans mature, owners may discover that refinancing at current rates results in substantially higher debt payments or lower loan proceeds.

In some cases, borrowers must contribute additional equity simply to refinance the existing loan balance. Owners who are unable or unwilling to inject new capital may be forced to sell, seek a recapitalization partner, or negotiate with their lender.

For buyers with available capital, these situations can create opportunities to acquire fundamentally sound real estate at a more attractive basis.

What Happens When Rates Decline?

Lower interest rates could improve transaction activity by reducing borrowing costs and increasing the amount of debt available to qualified buyers. A more favorable financing environment may also narrow the gap between buyer and seller expectations, bringing more properties to market.

However, investors should be cautious about building an acquisition strategy around the assumption that rates will quickly return to the historically low levels seen before 2022. Even if rates gradually decline, underwriting should remain based on realistic cash flow, conservative rent growth, adequate reserves, and sustainable debt coverage.

The strongest investments should work under today's fundamentals—not depend entirely on future rate cuts to generate acceptable returns.

A Market That Rewards Discipline

The current interest-rate environment has changed the way commercial real estate deals are evaluated. Investors are scrutinizing operating expenses, insurance costs, property taxes, capital improvements, debt terms, and exit assumptions more closely than they did during the era of inexpensive capital.

For disciplined buyers, this environment can be advantageous. Reduced competition, refinancing pressure, and pricing adjustments may create opportunities that were unavailable when capital was abundant and valuations were rapidly rising.

Interest rates will continue to shape commercial real estate investment decisions, but they are only one part of the equation. The quality of the underlying property, its location, income potential, replacement cost, and long-term demand remain fundamental.

Ultimately, successful CRE investors are unlikely to be those who perfectly predict the next interest-rate move. They will be those who acquire quality real estate at a sustainable basis, use appropriate leverage, and maintain the flexibility to navigate changing market conditions.