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Why Recession may not be bad for Real Estate

Everyone seems to be afraid of the looming recession owing to an upward pressure on the interest rates and justifiably so, but is it all that of a bad news?

Perhaps not!

Let us discuss the potential upsides to the rising interest rates, especially in the real estate industry.

Increases in the interest rate will create a healthier real estate market over the long term.

Real estate is often heavily financed with debt and as debt became cheaper, the prices in relation to Net Operating Income went higher. This negatively impacted commercial real estate in the following manner: -

  • The cash-on-cash yield became almost negligible in the market on a majority of deals.

  • The cap rates (= NOI/property value) fell to historic lows of 3-4%.

  • In order to maximize the IRR, investment firms were incentivized to return the capital to investors quickly leading to a lot of investors shifting their focus to short-term holding periods.

  • For long-term investors looking for properties with solid fundamentals, it has been difficult to find deals because investors are willing to overpay by underwriting double-digit rent growth percentages and cap rates that remain historically low.

Rising interest rates will put an upward pressure on the cap rates. Let us take a look at why that would be a boon.

As interest rates continue to grow and fear of an economic contraction seems to haunt everyone, buyers are forced to factor in the increased rates and make more conservative rent growth assumptions which have started to shift the real estate market towards healthier fundamentals.

As the cap rates will adjust upwards, it will lead to higher cash flow yields, lower leverage, and people choosing to go the agency route which will lead to less risk in the market.

With higher going-in yields and a normalized market from a cap rate perspective, investment opportunities for investors going in with a significant amount of capital will also increase.

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