How Rising Interest Rates Impact Commercial Real Estate

The Federal Reserve's interest rate decisions ripple through every corner of commercial real estate. Whether you're buying, selling, or holding property, understanding this relationship is crucial for success.

The Fundamental Relationship

As interest rates rise, commercial property values typically fall.

Here's why:

1. Higher Borrowing Costs

Debt Service increases with higher interest rates
Cash Flow decreases as more income goes to mortgage payments
Buyer Demand drops as fewer deals pencil out

2. Cap Rate Expansion

Cap rates and interest rates tend to move together:

When 10-year Treasury yields rise, cap rates rise
Higher cap rates mean lower property valuations
The spread between cap rates and bond yields compresses

3. Reduced Leverage Returns

Leverage amplifies returns in low-rate environments but can work against you when rates rise:

Low Rate Example (3% interest):

Property generates 6% cap rate
Debt at 3% interest
Spread: 3% positive leverage

High Rate Example (7% interest):

Property generates 7% cap rate (compressed)
Debt at 7% interest
Spread: 0% (negative leverage possible)

The 2022-2024 Rate Cycle

Historical Context

2020-2021: Fed Funds Rate near 0%
2022-2023: Aggressive rate hikes (0% → 5.5%)
2024: Rates hold steady at 5.25-5.50%
2025 Outlook: Potential gradual cuts to 4.5-5.0%

Market Impact

From 2022-2024, we observed:

Transaction volume down 40-60% from peak
Property values declined 15-30% in some sectors
Cap rates expanded 75-150 basis points
Distress increased, especially in office sector

Sector-by-Sector Analysis

Industrial/Logistics ⚠️ Moderately Affected

Why Resilient:

Strong fundamentals (e-commerce growth)
Low cap rates provide cushion
Long-term leases protect NOI

Impact:

10-15% valuation decline
Cap rates: 4.5% → 5.5-6.5%
Still seeing institutional demand

Multifamily ⚠️⚠️ Significantly Affected

Why Vulnerable:

High transaction volume = price discovery
Compressed margins with rising expenses
New supply hitting market

Impact:

15-25% valuation decline in some markets
Cap rates: 4.0% → 5.5-6.5%
Rent growth slowing

Office 🚨 Severely Affected

Why Crisis:

Work-from-home reducing demand
High vacancy rates
Short-term leases expiring

Impact:

30-50% valuation decline (urban Class A)
Cap rates: 5.5% → 8-10%+ (if findable comps exist)
Distress sales and foreclosures

Retail ✅ Mixed Performance

Why Varied:

Strong: grocery-anchored, necessity retail
Weak: mall-based, discretionary retail

Impact:

Grocery-anchored: stable to +5%
Regional malls: -20-40%
Strip centers: -10-20%

What Investors Should Do

1. Focus on Cash Flow

In higher-rate environments:

Prioritize properties with strong, stable cash flow
Avoid speculative value-add plays requiring refinancing
Emphasize credit tenants with long leases

2. Stress Test Everything

Run scenarios for:

Cap rate expansion (+100-200 bps)
Refinancing at higher rates
Recession-level vacancy (20-30% higher)
Tenant defaults and re-leasing costs

3. Target Value Opportunities

Rising rates create opportunities:

Distressed sellers needing to exit
Motivated owners with debt maturities
Portfolio repositioning by institutions

4. Adjust Return Expectations

If targeting 12% IRR, you may need to accept:

Lower leverage (50-60% LTV vs. 70-80%)
Higher equity contributions
Longer hold periods
More conservative underwriting

The 2025 Outlook

Potential Rate Cuts

Fed may cut rates if:

Inflation reaches 2% target
Economic growth slows
Labor market softens

Expected path: 3-4 cuts totaling 75-100 bps

CRE Recovery Timeline

2025: Transition year

Sellers adjust to new pricing reality
Transaction volume recovers modestly
Cap rates stabilize but don't compress

2026-2027: Gradual recovery

Volume returns to normal levels
Pricing stabilizes sector-by-sector
Industrial and multifamily lead recovery

Office: Separate trajectory

Restructuring continues through 2026+
Conversions to residential/mixed-use
Class B/C faces continued pressure

Key Metrics to Watch

10-Year Treasury Yield - Leading indicator for cap rates
Fed Funds Rate - Directly impacts short-term borrowing
Debt Spreads - SOFR + 250-350 bps currently
CMBS Market - Indicator of lending appetite
Transaction Volume - Recovery signal when it rebounds

Historical Perspective

Previous Rate Cycles:

2004-2006 Rate Hikes

Fed raised rates from 1% → 5.25%
CRE values continued rising (temporarily)
Subprime crisis followed in 2007-2009

1999-2000 Dot-Com Era

Rates raised to 6.5%
CRE held steady, tech bubble burst
2001 recession hit office hardest

1994 Rapid Hikes

Fastest rate increase in modern history
CRE adjusted quickly, recovered by 1997
No systemic crisis

Lesson: CRE is cyclical but resilient over time.

Actionable Strategies

For Buyers

Wait for sellers to capitulate on price
Focus on properties with assumable low-rate debt
Target distressed opportunities with caution
Plan for 5-10 year holds

For Sellers

Accept lower valuations or wait
Highlight assumable financing
Consider seller financing to close deals
Focus on credit quality of tenants

For Holders

Refinance long-term before rate cuts
Lock in fixed-rate debt if floating
Shore up reserves for debt maturities
Consider asset sales if facing refi cliff

The Bottom Line

Interest rates are the single most important external factor affecting commercial real estate values. While rising rates create short-term pain, they also:

Reset valuations to sustainable levels
Create opportunities for patient capital
Reward investors with strong fundamentals
Separate quality assets from speculative plays

At USLand, we provide transparent cap rate data, debt assumption options, and market analysis to help you navigate any rate environment.

Ready to find your next investment? Explore our curated CRE listings at USLand.com