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With the Fed still really unclear on when or if they'll adjust interest rates throughout the rest of this year, commercial real estate transaction activity is still lagging very far behind historical averages. But if we do see rates drop as we move into the second half of 2025, there are certain types of investors and certain types of investment strategies that might benefit the most when these changes ultimately go into effect. So, in this video, I want to walk through the biggest potential winners if interest rates do fall in the near future and the impacts these changes could have on the industry as a whole.
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So, to start, the first thing that's worth noting about falling interest rates is that when this happens on a very wide scale, cap rates in the market also tend to decrease. And since the value of a commercial property can be calculated based on the annual net operating income it can generate divided by that cap rate figure, the lower the cap rate, the higher the valuation, all else being equal. But when cap rates fall, not all investors benefit equally. And the biggest winners in these situations are the owners of properties that already trade at relatively low cap rates. For example, let's say that interest rates fall substantially on commercial real estate loans and cap rates end up dropping by 100 basis points. And this means that a property trading at an 8% cap rate would now be trading at a 7% cap rate with that same exact NOI, meaning the value of that property would increase by 14%. However, for a property that was trading at a 6% cap rate and now trading at a 5% cap rate after those interest rate decreases, the value of that property would now increase by 20% overall. And if we assume that both of these properties were acquired with a 60% LTV loan, which is relatively standard for many commercial real estate investors, while the owner of the 7% cap rate deal would see their equity value jump by 36%, the owner of the 5% cap rate deal would see their equity value increase by 50% as a result of these changes. And this all means that owners of properties that are already trading at the lowest cap rates in the market, which right now would be industrial and multifamily assets, are very likely to see the biggest benefits from decreases in interest rates. And owners of properties that are trading at the highest cap rates in the market, like suburban office owners would see the smallest benefit, all else being equal.
Now, beyond just an increase in valuations for certain property types, falling interest rates also make debt financing more affordable for investors, which typically leads to higher transaction activity across the board. And when transaction activity rises, transaction related revenue also rises for the majority of companies within this industry, including brokerage firms, lenders, and investment firms. Brokerage firms tend to see some of the biggest benefits from increased transaction volume since brokers typically only get paid when deals end up closing. Commission structures are also usually based on a percentage of the overall sale price of a property, which means that as valuations increase over time, that total commission amount also tends to rise. And for lenders, drops in interest rates tend to be even more impactful since an increase in transaction activity also often leads to an increase in lending activity for buyers of these properties. While at the same time, existing owners of commercial real estate are much more willing to entertain a refinance. Commercial real estate lenders also typically charge what are referred to as origination fees, which are based on a percentage of the total loan amount, which means that again, as more loans are issued and the size of those loans increases, the higher that fee income tends to be for the company. The same thing is also true for commercial real estate investment firms with increased acquisition fees as transaction activity rises and increased promoted interest earned on the back end of deals as valuations increase, which can make a huge difference for these companies when it comes to growing their teams. A lot of these firms have been really hesitant to hire over the last few years because this transaction related income has been so low and the budget just hasn't been there to bring on new talent. But if deal volume starts to pick back up in a meaningful way as a result of falling interest rates, we could also see a huge uptick in hiring in this industry, which is great news for you if you're looking to land a job in acquisitions, investment sales, debt and equity placement, or loan originations.
Now, investment firms benefit from increases in transaction volume. But if interest rates fall, some of the biggest winners are going to be groundup developers that are heavily reliant on changes to floating rate loans in their portfolio, which are typically used to finance development projects. The majority of construction loans in commercial real estate have an interest rate that floats or changes on a monthly basis and is directly tied to fluctuations in the secured overnight financing rate. And because commercial real estate development projects can take anywhere from about 18 months to 3 years or more to complete, a major drop in interest rates during that construction period can have a material impact on the total cost of a project. And with the cost of labor and materials rising significantly over the last few years, developers don't have that much margin to work with in the first place. And any sort of savings related to interest costs owed can make a huge difference in the profitability of a groundup development deal. A drop in interest rates could also make new groundup development projects more feasible for developers, which could lead to more deals getting done and more revenue for these firms related to land acquisition fees, asset management fees, or construction management fees that are required to develop these projects.
Now, with all of those things said, it's worth noting that just because the federal funds rate decreases doesn't necessarily mean that all interest rates will fall on commercial real estate loans. For example, on acquisition loans used to finance existing commercial properties, these often come with a fixed interest rate. And US Treasury yields tend to be the index rates used to price this debt. And when the Fed made their first rate cut in the fall of 2024, the 10-year US Treasury actually increased over the next four months, going from 3.63% in September to 4.79% in the middle of January, even as the federal funds rate decreased during this time. But on floating rate loans like what a developer might use to finance a construction project, the secured overnight financing rate or SOFR tends to be the index rate used for pricing, which does typically have a direct correlation with changes in the federal funds rate. And this has dropped from roughly 5.34% in September of 2024 down to just 4.3% as of the end of June of this year. But regardless of what happens with the Fed, the cost of debt right now is having a lot of negative effects on transaction volume and valuations in commercial real estate. And if those costs go down throughout the rest of this year, there could be some very big changes on the horizon for certain parts of this industry.
If you're watching this and you want to make sure you're ready for the interview process when hiring does inevitably start to pick back up again, and you want to make sure you have the technical skills you'll need to make it through an Excel modeling exam that might be given to you during the process, make sure to check out our all-in-one membership training platform, Breaking a CRE Academy. A membership to the academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis. You'll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you'll also get access to the Breaking a CRE analyst certification exam, which covers topics like real estate proforma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.
And if you like this video and want to see more content on the impacts of potential interest rate changes in this industry, make sure to hit the like button and let me know. And let me know in the comments when you think interest rates might start to fall and why you think that might be the case. As always, thanks so much for watching, guys. I hope you found this helpful. Subscribe to the channel if you haven't already to see more videos like this every single week. And I'll see you in the next video.
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