Interest Rate Pressure on Property Value

The real estate market is unique in the way that property prices are formulated. There are various methods of pricing property such as the sales comparable approach, the income approach, and the cost approach. Each of these techniques attempt to use as much logic as possible when pricing properties, but at the end of the day, it is up to the owner to decide which pricing route they would like to take.

When strictly speaking about commercial investment properties, owners tend to get in the mindset that the property’s income is the sole driving force of its value. But this is really not the case. In fact, interest rates have more control over your property value because expensive lending decreases the overall yield. I suspect that owners fail to think of this side because they are not the people that are required to finance the purchase of the property. It is critical that current interest rate trends are taken into consideration when pricing investment properties.

To give you the perspective of the buyer, they have two options when interest rates go up: they can either increase their down payment by nearly 10%, or they can wait on the sidelines and buy property when the market inevitably dips. When financing a property, the lender has to meet a minimum debt service coverage ratio (DSCR) of 1.25 – 1.35. If the DSCR is too low, then the bank will look at the buyer to put more money down. Following is a table that shows this breakdown:

For sellers, a judgement call needs to be made. “Do I lower my price expectations to fit the current market conditions, do I wait for an exchange buyer, or do I not sell my property?” If you still want to sell you property, then you need to ask yourself what the current market price is.

Rather than leaving you hanging here, I have done the math to show how interest rates directly affect property value…

Assuming that NOI and all loan terms stay constant, an interest rate rise from 4.5% to 5.5% results in logical property value decline of more than 10%.

Fair market pricing is necessary because rising interest rates add to the riskiness of investing. In addition to this, the falling knife analogy explains how investors are often unwilling to invest during recessions because a bearish market will immediately devalue recently purchased investments. When the market goes down, there are less investors willing to place money, which makes overpriced properties even less likely to find a qualified buyer.

Selling during a downturn is a tough spot to be in as a seller. It is hard to look at sales comps from six months ago that price your property 10% higher than its current value, but pricing with consideration to interest rate trends is the only way to offload your real estate. My words of wisdom are to price your property to sell in two months rather than sell two months ago.