Single-family homes are appraised and valued based on market trends. Commercial properties are valued very differently. The value of any commercial real estate property is based on its Net Operating Income (NOI). NOI is simply the rental income from the property minus any operating expenses.
To calculate the value of a commercial property, you take the NOI and divide it by a rate known as the capitalization, or cap, rate. The cap rate is essentially the return that an investor expects to earn on their investment.
For example, if an investor is looking for a 10% return on their investment, they would use a cap rate of 10%. So, if the property has an NOI of $100,000, the property would be worth $1 million. ($100,000/$0.10).
Now, here’s where things get interesting. Cap rates generally correlated to interest rates. There is no rule that states that they must, but they almost always do. As interest rates increase, so do cap rates. In contrast, as cap rates increase, the value of the property decreases.
To put it simply, when interest rates go up, the value of commercial real estate goes down.
But it’s important to remember that rent increases don’t lead to inflation. Rather, rental rates react to inflation. So as inflation increases, rents also increase and so does the NOI. Therefore, even though increasing interest rates put a crunch on property values, the income from the property will actually increase.
In other words, while higher interest rates may not be good news for property values, in the end they can actually be beneficial for commercial real estate investors.