How Interest Rates Impact Commercial Real Estate Demand

Interest rates are one of the most influential factors shaping commercial real estate (CRE) markets. Whether you're an investor, developer, or tenant, changes in interest rates can significantly impact decision-making, valuations, and overall market dynamics. While rising rates can present certain challenges, they also create opportunities for strategic growth and resilience in the industry.

The Cost of Borrowing

At the most basic level, interest rates determine the cost of borrowing. When rates rise, loans for property acquisitions or new developments become more expensive, which can affect buyers' purchasing power. Conversely, when rates are low, debt is more affordable, making it easier for investors and developers to finance deals or launch new projects.

This relationship often makes CRE demand more sensitive to interest rate fluctuations. However, even in a rising rate environment, well-positioned assets in strong markets continue to attract interest, especially from buyers focused on long-term value creation.

Cap Rates and Property Valuations

Interest rates also influence cap rates—one of the most widely used metrics in evaluating CRE investments. Cap rates tend to rise with interest rates, especially as investors compare real estate returns to alternative investments like bonds. As cap rates rise, property values may adjust downward unless net operating income increases to offset the change.

Still, this isn’t necessarily negative. A recalibration in values can open the door for buyers who were previously priced out of competitive markets, while current owners with high-quality assets and stable tenants may find their properties even more attractive as safe, income-generating investments.

Competition from Other Investment Vehicles

As interest rates rise, conservative investments such as government bonds or savings accounts start offering higher yields. This can shift capital away from real estate in search of lower-risk options. That said, commercial real estate remains a compelling asset class due to its ability to generate steady income, hedge against inflation, and provide tax advantages.

For many investors, especially institutional ones, CRE continues to play a key role in portfolio diversification, even when interest rates move upward.

Development Activity and Feasibility

Higher borrowing costs can affect the feasibility of new development projects. Construction loans become more expensive, and in some cases, projects may be delayed or scaled back to preserve returns. This is particularly relevant for asset classes already facing headwinds, such as office or certain segments of retail.

However, in-demand sectors like industrial, multifamily, and well-located mixed-use developments often continue to pencil out—especially in growing markets with favorable demographics and business expansion.

Tenant Demand and Business Health

Interest rate environments can also indirectly impact tenant demand. For example, rising rates may slow overall economic growth or increase operating costs for businesses, prompting some tenants to reevaluate their space needs.

That said, sectors like logistics, healthcare, life sciences, and experiential retail continue to show strong leasing momentum, driven by structural shifts in consumer behavior and supply chain strategies.

A Resilient Industry with Long-Term Opportunity

While interest rates undoubtedly shape the short-term dynamics of the commercial real estate market, the industry's long-term fundamentals remain strong. Demand for quality space, evolving tenant preferences, and continued investment in infrastructure and technology all contribute to a resilient and adaptive market.

For investors and stakeholders, understanding how interest rates influence demand is essential for making informed, forward-looking decisions. With the right strategy, commercial real estate continues to offer meaningful opportunities across market cycles.

Written by LevRose CRE with assistance from: LevRoseCRE.(2024)

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