As the commercial market had a strong recovery in 2021, commercial sales prices rose across all core asset classes. Prices of multifamily properties and industrial properties rose at the strongest pace by over 10% year-over-year while sales prices on retail and office properties rose at a modest pace of less than 5%.1 These price appreciations exceed pre-pandemic price appreciation growth rates, except for the office sector.
As interest rates increase, one natural question that arises is the effect on commercial prices. Based on the demand and supply conditions in these property markets, there is a greater likelihood that valuations of commercial properties will remain firm, except in the office market which is facing an elevated vacancy rate. The pace of price appreciation in the retail property market could also slow due to reduced consumer spending as inflation erodes purchasing power.
Currently, vacancy rates are very low, with absorption (demand) outpacing deliveries (supply) (minus in the office market), according to CoStar® market data. As of March 2022, vacancy rates remain low in the multifamily (5%), industrial (4%), and retail (4.5%) properties market, with an elevated vacancy rate only in the office property sector (12.3%). Rising interest rates also impact the cost of financing, which can negatively affect construction activity. With net deliveries already trailing behind net absorption (except in the office market), higher interest rates will tend to tighten the availability of commercial space and prop up rental income, and therefore the value of an asset.
The 12-month net absorption (demand) is outpacing the 12-month level of deliveries (supply) in the multifamily market, even in metro areas like New York, San Francisco, and Washington, D.C.
Moreover, higher mortgage rates impact home affordability, which tilts demand toward renting. Based on NAR’s forecast of the median sales price in 2022 of $364,700,2 the uptick in mortgage rates from 3.6% to 5% will make homeownership unaffordable for 1.8 million renter households headed by 25-44-year-old persons. Renter households with a family income of less than $85,200 will find a home purchase unaffordable.
In the case of the office market, workers are also heading back to the office, increasing the demand for office space. As of February 2022, only 13% (or 20 million) of the workforce worked from home, down from 35% (or 49 million) in May 2022.
However, higher interest rates pose the most downside risk to demand, rents, and prices in the office and retail property markets. In the office market, metro areas with high vacancy rates and weak rent growth (particularly New York, San Francisco, and Washington, D.C.) have the highest risk of rents and commercial prices further declining. As of March 2020, rents are still declining 1.7% year-over-year while sales prices are down 0.4% in the San Francisco metro area. In New York, office rents are down 0.8% while sales prices are down 2.3% on average. In the Washington, D.C. market, rents were down 0.5% year-over-year as of March, but sales prices were up at a modest pace of 0.9%. Slower economic growth and rising transportation costs dampen the demand for office space and the rationale for requiring workers to report to the office. However, the effect of long-term demand fundamentals (net domestic migration) on office demand in Florida, Texas, Utah, Idaho, and Arizona will likely help mitigate or offset the negative effect of higher interest rates on the demand for office space.
In the retail property market, vacancy rates have declined—except for malls, which have an elevated vacancy rate of 8%, making them vulnerable to price declines as real consumer spending weakens, with rising inflation eroding consumers’ purchasing power. Inflation surged to 7.9% as of February 2022 and could further increase through the summer as oil prices hover at over $100/barrel.
1 Source of data: CoStar
2 Forecast as of February 2022