Interest Rates and Cap Rates
Great piece from "Globe St." on the relationship between Cap Rates and Interest Rates. This analysis echoes many others that we have seen in the past year or so: namely, that there is a lot of room for interest rates (particularly in the front end) to move up without any noticeable impact on commercial real estate cap rates.
From the article:
Historical data show that cap rates and 10-year Treasury yields don’t necessarily move in lockstep. More importantly, the report says, the data show that changes in Treasury yields don’t necessarily result in changes in cap rates. “Even assuming lags between interest rate and cap rate changes, analysis found no statistically significant relationship between the two variables,” the report states.
Cap rates are influenced by “a wider network of variables beyond interest rates,” including real estate fundamentals, capital flows and investor risk appetite. Thus, the impact of rising interest rates on real estate performance is difficult to predict, according to the TIAA-CREF report. “Indeed, the outlook for real estate in a rising rate environment depends on a variety of factors specific to the current and expected economic and property market environments.”
While the report acknowledges that fears that the eventual rise in interest rates will result in higher cap rates and declining property values “seem reasonable,” in fact these anxieties “oversimplify and ignore variables that have the potential to offset value declines.” It cites a number of factors that can protect overall property performance in a rising interest rate environment, such as the spread between cap rates and 10-year Treasury yields.
The current cap rate spread, for instance, is just over 300 basis points, about 30 bps higher than the long-term historical average of 270 bps. “The extra spread can absorb a small increase in 10-year Treasury yields and/or a further reduction in cap rates before property values are affected,” according to the report, and therefore can be seen as a “a slight protective buffer” from the expected rise in interest rates.