Interest Rate directly proportionate to Growth

By Kison Patel, President, National Hotel Exchange

Growth in commercial development has been strong in the last several years. Coming out of the economic boom of the late 1990's, the economy was strong and consumers were spending. Though confidence was high, the real estate market was relatively flat. The reason? Interest rates.

In the late 1980's, interest rates on mortgages were hovering around 11 percent making huge investments very unattractive. They gradually lowered until early in the millennium when they hit historical lows. By 2003, interest rates had declined to 3 percent. But what effect does that really have on real estate development?

It is well known that high interest rates result in high mortgage payments. This, of course can be offset by increasing investor capital upfront lowering the outstanding debt subject to interest. But in an era of high interest rates, it may be more difficult to find investors to risk their capital on your project.

In a low interest rate environment, however, the positive effects are seen in both new development as well as existing commercial enterprises. Property owners who had been struggling after the tepid economic growth following the recession benefited from these interest rates and were able to refinance their holdings and lower their debt burden.

This was particularly effective for the hotel markets. After 9/11, due to anxiety about travel, the hotel industry suffered prolonged weakness in revenue per available room in several markets. The low interest rates enabled them to refinance debt that had been incurred during these times. More importantly, it gave them the ability to use the equity they had built in their properties to improve their cash flow and utilize it to make repairs or upgrades which had been put off during the sudden economic downturn.

Properties that had been purchased in the 1980’s when interest rates were high benefited the most from the low interest rates. By refinancing at the lower interest rate and taking advantage of the opportunity to utilize their equity, they not only increased the value of their properties by making improvements, but also lowered their mortgage payments. The net effect for them was increased cash flow which they were able to turn into increased capitalization rate once the tourist market was back on track.

One other factor worth mentioning is the role REIT’s played during the sluggish economic times. They became a major force in financing commercial real estate and experienced a more than seven-fold increase in market size in the last decade. Together with Commercial mortgage-backed securities (CMBS), which experienced a greater public involvement in the 90’s, they appeared to have taken on a larger share of the traditionally higher-risk types of loans. This type of financing takes the pressure off of traditional bank financing and lowers the risk to individual investors by spreading the risk out over several properties in the portfolio, much as a mutual fund mitigates risk in traditional investments.

Due to the variety of investing potential available, and the recent growth patterns we’ve seen in the economy, the future of the commercial real estate market looks promising. The investment potential is nearly unlimited as housing developments are springing up in heretofore untouched and undeveloped areas of the country. With residential developments come all of the associated necessities such as hospitals, schools, shopping centers and hotels. With interest rates still far lower than a decade ago, the bubble has not yet burst on this lucrative market.

Kison Patel is President of National Hotel Exchange and Principal of TransAtlantic Investments & Advisory. He is a specialist in middle market transactions. He can be reached at kison@nationalhotelexchange.com or kison@tafunds.com