What happens to cap rates as interest rates rise?

Question

Hey pocketeers,

We are at historic low cap rates, do they go up as interest rates rise?

Mike Dymski · Answer

Theoretically, interest and cap rates move directionally together.  There comes a point where the spread between the interest and cap rate make investing unattractive.  The real estate market is more complicated than that though and there are many other factors that drive demand, such as the flood of capital into the marketplace and the available alternatives for parking ones money.

I was at lunch yesterday with my lender, the lead commercial broker in my area, and a couple of large local investors and the president of the bank asked that exact question.  The large local investor sitting next to me pulled out his loan amortization calculator on his phone, stress tested rates 50 basis points, and commented that it would not impact him to any material degree.  I was (facetiously) kicking him under the table to not mention his rate insensitivity with his lenders sitting in front of him....but he was not concerned with the upcoming anticipated rate hikes.

Many investors try to invest in assets where interest rates are down on the list of their concerns...they are buying below market, adding value, or other strategies where the cost of money is not the largest issue.

Joel Owens · Answer

I like STNL.

Multifamily to scale and be passive might have to be 80 to 100 doors or higher.

For most that makes them either a syndicator as a sponsor or they are buying less doors and have to be active in some way on the asset.

Lot's of multifamily is overvalued in the cycle. If this was 4 to 5 years ago I might feel different about multifamily . Benefit to getting passive owning directly is in most cases you can't do that with 1 million of multifamily. You can do that with a 1 million dollar STNL property.

I do not want any investment where I am buying myself a job.

Take multifamily to get decent tenants and say you have 80 doors at 80k a door that is 6,400,000 to get passive for scale versus 1 million STNL. Multifamily is more cyclical. In downturn taxes are high, and expenses get higher, vacancy goes up, and rent tends to flat line.

STNL you have a long term lease in place and the tenants shoulder increasing costs and no matter if economy is going up,down, sideways you are getting XX percent each year increase.

No asset class is perfect. You can lose money on any asset if you buy incorrectly. I am not against multifamily. I do not see it as the darling that many people do. People are buying on bubble numbers of the last 1 to 2 years and pro-forma the number like it will last another decade after they own it.

There are certain rent ranges like Cardone mentioned where no matter the cycle they tend to hold up well. Just have to be really careful. If I did multifamily it would only be hundreds of units or more.

Jeff Copeland · Answer

Debt service / financing costs are not even included in the cap rate formula (the calculation of cap rate assumes a cash purchase). So technically interest rates do not affect cap rate rate performance directly.

In a similar vein, interest rates do not affect the operating costs of a property (debt service is not an operating expense).

So the real question, then, becomes How do rising interest rates affect the price of investment properties? (Since purchase price does have a direct impact on the cap rate calculation).

The answer, it seems, is It's complicated. There are too many other macroeconomic factors to consider.

Here's a recent article that hits on some of these: https://www.cnbc.com/2017/03/23/rising-interest-ra...

And note that this only affects the cap rate calculation for a property you're currently buying or evaluating for purchase.

On a property you already own, interest rates have no effect on your cap rate whatsoever.

Joel Owens · Answer

I would look at HOW the cap rate is being underwritten.

Not what the seller or broker is underwriting or even what they bank is underwriting to qualify for a loan. As a buyer you need to look at market historical over decades for the asset class in this case multifamily.

If sellers are selling 6.5 caps but using 4 to 5% rent growth, 3% vacancy, 35% opex etc. then really you are likely buying a 5 cap on existing.

Historically over decades many markets average 1 to 2% rent growth, 10% vacancy, 50 to 60% opex. A seller might really have 35% opex in a newer type building or rehabbed. The next 10 years you own it the expenses might be a lot more as your life expectancy on many items runs out. This is why you have to look at big ticket cost items upfront and get a credit before closing. Hoping increased cash flow or the same cash flow you have going in will be there in the future can be a recipe for disaster. If cash flow stagnates or goes down and repairs increase you could be in an ongoing loss position with debt you cannot get rid of.

When interest rates rise lenders tend to bring out new loan programs that buyers want to purchase in the market. If lenders cannot sell loans for what buyer want to buy they are not in business. Having said that lenders will not put certain loans out there until the consumer or market demands calls for them to keep doing business. Cap rates tend to rise some but also you get reduced selling volume in the market as sellers will hold and keep equity unless they have to sell at an inopportune time in the market.

It also depends on what deal size. There might be a lot of all cash buyers sub 3 million if loans do not work anymore but on larger properties most buyers would be placing some debt so a loan comes into play. There are a lot of variables.

What I like about commercial real estate for myself is if I develop a STNL property with a long term 15 or 20 year lease and the average real estate cycle is 7 to 10 years then I can decide when it's best for me to sell or refi.

Armando Payano · Answer

I would think, theoretically, that as interest rates rise cap rates would follow.  If money is “cheaper” now, due to low interest rates, there is more of it chasing supply. Which leads to investors accepting less return thus compressing cap rates. If money becomes more “expensive” due to rising interest rates that money becomes less willing to accept lower returns thus forcing selllers/market to adjust. That’s my theory anyway. Interested to hear others. Although it’s all theory and theory if for the classroom not the real world where each deal is more dependent on local market conditions.

Tony Nguyen · Answer

Hi Joel, for your personal portfolio, which do you prefer - STNL's or Multifamily? If STNL's, what type?

David Thompson · Answer

Hi Will,

Yes, about 7 factors influence cap rates and two are the ones you hear most about and that is interest rates and supply / demand for the asset.  They don't move in lock step.  For instance we've seen several interest rate hikes since the Trump administration came in and cap rates in Dallas have not moved up since the strong demand for these assets are proving a stronger counterbalance for now.  The chart below of Dallas cap rates since 2005 (provided by REIS).  Note that cap rates in 2011 were 5.5% in Dallas for MF apts not far off from where they stand today.

Mike Dymski · Answer

If that's your prediction, I'd recommend shorting the stock market.  He used 50 basis points as an example...I believe the market is expecting 75 basis points through 2018...who knows.  Many investors just deal with what they can control which includes the assets they purchase and the loan terms they look for.

Most of the investors I know are buying below market, adding value, locking in for longer terms, and getting assumable loans all to mitigate risk.  The investor I mentioned in my previous post was selling an asset for $18 million that he purchased six months earlier for $14 million.  Many investors are doing the same on a smaller scale.  Rates and markets are unpredictable but adding value, locking terms, and mitigating risk are not.

Will G. · Answer

Apartment opex survey ran across this and thought very useful info on opex.

I too wonder what cap rates were like when interest was @ 18%!

Taylor L. · Answer

@Mike Dymski 50 basis points hardly seems like a representative potential interest rate hike though. What if rates fly up to levels in the late 70s/early 80s?

What happens to cap rates as interest rates rise?

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