The relationship between the fed funds rate and commercial real estate asset values is indirect but significant.

 

While the Fed does not directly set CRE lending rates, its actions create a ripple effect. CRE loan rates are typically based on a spread over a benchmark rate, such as the 10-year U.S. Treasury yield for asset transactions or the SOFR for development deals. These benchmark rates, in turn, are influenced by the fed funds rate.

 

When the Fed raises the fed funds rate it makes it more expensive for banks to borrow. This increased cost of funds for banks leads them to raise the interest rates they charge on all types of loans, including those for CRE.

 

Conversely, when the Fed lowers the rate to stimulate the economy, it becomes cheaper for banks to lend, and they can offer lower rates on CRE loans. This relationship isn’t always perfectly synchronized, as other factors like market demand, inflation expectations, and economic outlook also play a role. Currently, the national debt is a great concern for bond investors, and many are passing up the opportunity to acquire long-term treasuries, a factor that is pressuring the long end of the yield curve higher in 2025.

 

How Lending Rates Impact CRE Property Prices

The impact of lending rates on CRE property prices can be understood through two main channels: borrowing costs and valuation.

 

1. Borrowing Costs and Investor Demand

 

For most investors, buying commercial property requires a loan. When lending rates rise, the cost of borrowing goes up. This means the monthly payments on a property increase, reducing the amount of cash flow an investor can pocket. To make a deal financially viable, investors often need to pay a lower price for the property to compensate for the higher debt costs. This reduction in the amount an investor is willing to pay leads to a decrease in property prices.

 

Conversely, when lending rates fall, borrowing becomes cheaper. This allows investors to pay a higher price for the same property while still achieving their desired return, which increases property prices.

 

2. Property Valuation

 

When lending rates rise, investors typically demand a higher cap rate on their investments to offset their higher borrowing costs and the increased return available on other, lower-risk investments like Treasury bonds. If a property’s NOI is fixed, a higher cap rate means the property’s value must decrease. For example, a property with a $100,000 NOI would be worth $2 million at a 5% cap rate, but only $1 million at a 10% cap rate.

 

In short, higher lending rates lead to higher cap rates, which in turn put downward pressure on CRE property prices. The opposite is true when lending rates fall, leading to lower cap rates and higher property prices.

 

3. Investor Sentiment

 

While vague, investor perceptions about the economy and the future will impact their decision-making. The Fed meetings and policy are well tracked by CRE professionals, and cuts usually inspire a great deal of confidence in the market. It is possible that by continuing rate cuts, investors will feel more confident in the state of the economy, pursue more deals, and in turn, raise prices through increased purchasing activity. More potential buyers can create bidding wars.

 

Case Study: 2020

 

When the Fed cut rates in 2020, it played out exactly as the theory suggests: commercial real estate lending rates dropped to historic lows, which made borrowing cheaper and had a positive, albeit uneven, impact on property prices. The Fed’s swift and aggressive actions were a response to the economic crisis triggered by the COVID-19 pandemic.

 

The Fed’s Rate Cuts and Response

In March 2020, as the pandemic began to shut down the economy, the Federal Reserve took emergency action, slashing its benchmark fed funds rate from a range of 1.50%-1.75% down to 0%-0.25% in a matter of weeks. This was part of a larger strategy that also included a massive bond-buying program, known as Quantitative Easing, which specifically included commercial mortgage-backed securities. The goal was to flood the financial system with liquidity and keep the economy from collapsing.

 

Impact on CRE Lending and Prices

The dramatic drop in the fed funds rate caused a corresponding plunge in long-term benchmark rates, such as the 10-year U.S. Treasury yield. As a result, the cost of borrowing for commercial properties fell significantly. This made CRE loans more affordable for investors, directly impacting property prices through the two channels mentioned previously:

 

• Borrowing Costs: The lower lending rates reduced the cost of financing for new acquisitions and refinances. This increase in affordability allowed investors to pay more for properties while still meeting their return targets, which put upward pressure on property values.

 

• Cap Rates: The low-interest-rate environment caused a compression in capitalization rates across the CRE market. With other investment options, like government bonds, yielding very little, investors were willing to accept lower returns (a lower cap rate) for the relatively higher income from commercial properties. This inverse relationship between cap rates and value led to a general increase in CRE prices.

 

Case Study: 2008

 

The financial crisis of 2008 was a fundamentally different situation than the pandemic, and the relationship between the Fed’s actions and commercial real estate prices was much more complex and severe. While the Fed also cut rates, the economy was in a state of collapse due to a credit crisis, which completely broke the typical relationship.

 

The Fed’s Response and the Credit Freeze

Starting in late 2007, and accelerating throughout 2008, the Federal Reserve began aggressively cutting the fed funds rate. It went from 5.25% in September 2007 down to a range of 0%-0.25% by December 2008.

 

However, this rapid rate cutting did not lead to an immediate surge in CRE lending. The f inancial system was in a state of shock, characterized by a complete credit freeze. The collapse of the subprime mortgage market and the failure of major institutions like Lehman Brothers created a crisis of confidence. Banks and lenders, unsure of each other’s solvency and facing massive losses on their existing loans and securities, simply stopped lending. This was true for both residential and commercial real estate.

 

Impact on CRE and Lending Prices

The credit freeze broke the usual link between the fed funds rate and CRE lending rates. While the Fed’s benchmark was near zero, the actual cost and availability of credit for businesses and real estate investors were skyhigh. Lenders demanded huge risk premiums, and many loans were simply not available at any price. The impact on CRE prices was a steep and dramatic decline driven by a complete lack of liquidity in the market.

 

• Borrowing Costs: Even though the fed funds rate was falling, the cost of a commercial real estate loan skyrocketed for the few borrowers who could even find a lender. This made new acquisitions financially impossible for many investors, who rely on debt financing to leverage their returns. The lack of buyers led to a massive drop in demand, and property values plummeted.

 

• Cap Rates: In a normal environment, a falling fed funds rate would lead to lower cap rates. In 2008, the opposite happened. Investors demanded an enormous risk premium, and the risk of properties becoming vacant or rents falling was perceived as very high. This caused cap rates to spike, which, by the valuation formula, caused property values to crash. Prices for commercial properties fell by about 40% from their late 2007 peak to early 2010.

 

The De-leveraging Cycle and Long-Term Recovery

The 2008 crisis was primarily a deleveraging event. Banks and financial institutions were forced to sell off assets—including commercial properties—to raise cash and shore up their balance sheets. This further depressed prices in the short run, creating a vicious cycle of falling values and forced sales.

 

However, the key takeaway is that once the credit markets began to unfreeze and lending rates caught up to the Fed’s near-zero policy, CRE prices grew rapidly. After the initial panic subsided, the lending market gradually recovered. The Fed’s commitment to keeping interest rates near zero for several years created an environment of extremely cheap credit. This low cost of capital made commercial real estate an incredibly attractive investment again, fueling a new wave of borrowing and investment. The flow of cheap debt into the market drove a significant and sustained period of CRE price appreciation that lasted for the next decade.