Interest Rates, Inflation and the impact on Commercial Real Estate – what should you pay attention to?

Part 1: The Interplay of rates, inflation and real estate

On the first Tuesday of November at around 2.30pm each year many Australians stop – not just to watch The Melbourne Cup – but to hear whether the Reserve Bank of Australia (RBA) has made the decision to adjust the cash rate target. In fact, this happens at least 8 times a year as part of the RBA’s regular monetary policy reviews.  

What exactly is the cash rate target and what should we pay attention to?  The cash rate is the RBA’s benchmark for the interest rate on unsecured overnight loans between banks. This rate directly influences broader financial conditions and, as such, is of particular importance to individuals with home loans, term deposits, or investments in private credit. 

Also referred to as the ‘Risk-Free Rate’, the cash rate represents the theoretical return on an investment with no risk of default. This benchmark can help investors assess whether the return they are earning adequately compensates them for the level of risk they are taking, particularly when compared to other investment risk profiles.

Changes to the cash rate target – or decisions to leave it unchanged – provide valuable insight into economic conditions, including inflation, economic growth, and monetary policy direction.  Adjusting the cash rate target, which directly influences interest rates, is a key tool that a Central Bank will use to try and manage inflation.  

The RBA has an objective to manage financial stability which in turn contributes to a stable economic environment.  In periods where inflation is too high or too low, the RBA can adjust the cash rate target as a mechanism to influence inflation, the control of which is a key component of its objectives.  However the cash rate target is only one tool available, and managing inflation within a target range requires taking into account  factors beyond the influence of cash rate adjustments.  For this reason, it is commonly referred to as a “blunt instrument” or “blunt tool” due to its broad, rather than precise, impact.

There is a clear and complex relationship between asset price changes and inflation.  As an example, rental yields are linked to both housing supply and the price of residential property.  When residential property prices increase and rents do not adjust, the running yield on investment properties reduces. While this may not immediately concern investors benefiting from capital gains, rents are likely to adjust upwards (assuming no significant changes to housing supply). This eventual rise in rents then contributes to inflation. 

Construction cost escalation is also a key contributor to the housing component of the calculation of the consumer price index.  When construction cost escalation is extreme (like we saw during COVID and through until 2023), this will impact the ability for housing approvals to convert into supply.  According to CoreLogic, the cost of building in 2024 was around 30% higher than pre-COVID levels. However, in June 2024 CoreLogic reported that construction costs were increasing at a slower rate than inflation, which is likely to have a positive impact on the inflation outlook.  

However, with wages not having increased anywhere near as high, the impact on mortgage affordability is now being felt.  Additionally, there is a slowdown in presales with buyers opting to wait until they can see the finished product before committing to purchase.  This trend likely stems from a combination of sustained higher interest rates impacting borrowing capacity, but also concern around the levels of construction company failures that have occurred in recent months/years. These concerns make buyers worried about potential delays, issues with construction completion, or the prospect of waiting for a development to finalise, preferring instead to invest in opportunities that offer immediate returns. In response, developers may feel the need to adjust price expectations to move stock, depending on market conditions and demand. 

On the supply side, a number of impacts have been felt due to prolonged higher interest rates including:

• Projects that have been in the pipeline for a number of years may no longer be financially viable.
• Combined with a slow-down in demand for presales, this is likely to impact the appetite for lenders to support projects.
• While national building approval figures have improved, they are recovering from the lowest levels recorded in the last 10 years (2023).

Where to from here? Despite the RBA being very careful not to suggest a timeframe for rate easing, the broad consensus among economists is that rates will likely start to adjust downwards by the middle of 2025 at the latest as the trend for inflation easing is more sustainable.  The number of potential rate cuts is a different story, and whilst all of these are simply predictions, the broader market is currently pricing in an end of year cash rate at 3.6%.

In Part Two, we will explore how the outlook for cash rates can impact returns on commercial real estate private credit. We will discuss how CRE loans are priced and discuss the opportunities and considerations for investors presented by prolonged higher rates, particularly when evaluating fixed rate loans in the context of a potential rate easing cycle.