7 Reasons Why Cap Rates Won't Rise With Interest Rates

▪ Why People Incorrectly Think Interest Rates & Cap Rates Are Correlated: Three common logical schools of thought:

     1. The 10-year U.S. Treasury rate serves as the de facto base line for expected returns and represents the “risk-free” rate. As the risk-free rate increases, so must cap rates. (Cap Rate = Risk Premium + Risk-Free Rate)

     2. Higher interest rates increase borrowing costs, which reduce the amount that can be borrowed, thus reducing purchasing power and driving prices down and cap rates up.

     3. Over the past 40 years, interest rates have fallen and so have cap rates.

When taken in a vacuum and holding all else equal, these statements are true! Unfortunately, we do not live in this oversimplified world, and it’s dangerous to not look at the historical and readily available facts and understand the dynamics of real-life markets.

▪ Actual Correlation of 10-year Treasury and Cap Rates: The correlation between cap rates and interest rates fluctuate frequently over time with some 5–10-year periods even having an inverse correlation.

▪ Why Isn’t There More Correlation? Ultimately, while interest rates do play a part in the pricing of real estate, there are many other drivers at play:

     1. Supply & Demand: Although maybe boring, traditional supply and demand dynamics still play a leading role in the fundamentals of real estate. Supply gluts or falling demand can lead to significant cap rate expansion regardless of interest rates and vice versa.

     2. Growth: During times of economic expansion, growth expectations are high. Investors use these growth expectations to justify paying more for a property, resulting in lower cap rates, regardless of interest rates. Coincidentally, the federal reserve often increases rates during these times of great growth to keep the economy from overheating, ultimately resulting in the simultaneous lowering of cap rates and increasing of interest rates. In a 2011 paper by Philip Conner, a principal at Prudential Real Estate, he found that during six periods of rapidly rising interest rates between the late 1970s and 2010, cap rates usually remained flat or decreased.

     3. Investor Confidence: Credit spreads can be used as a proxy for investor confidence. When investors have more confidence, they are willing to take smaller risk premiums (spreads). These fluctuations in risk premiums can more than offset any increase in interest rates during economic expansions, causing cap rates to stay flat or decrease despite interest rates increasing. Cap rates can even be viewed as more of a gauge of investor preference towards real estate versus other investments on a relative basis.

     4. Nominal vs. Real Interest Rates: Nominal Interest Rates = Inflation + Real Interest Rates. If the 10-year treasury increases due to expected future inflation, this interest rate movement may not have a meaningful impact on real estate cap rates since many real estate sectors can generate more income when inflation occurs. So, while investors buying 10-year treasuries may drive the yield up on treasuries due to inflation concerns, those same inflation concerns will not drive cap rates up.

     5. Market Liquidity: The overall amount of debt—more so than the rate—drives cap rates. Dr. Peter Linneman notes that “We clearly find that an increase in mortgage debt as a percent of GDP drives down cap rates.” With approximately 15% of all commercial real estate debt maturing each year, lender activity and the ability to refinance property play a crucial role in real estate pricing. Short- and long-term debt cycles (more so than rates) play a major factor in cap rates and real estate pricing. See our prior article on “Principles For Navigating Big Debt Crises” by Ray Dalio.

     6. Capital Inflows: Real estate was once viewed as part of the “alternative” asset class but is now being carved out as its own asset class, rightly so. This means, more and more asset allocations are being directed specifically into real estate. Additionally, with new technology and the rise of crowd sourcing, more people than ever have access to real estate investing. This overall inflow of capital to the real estate space has helped drive cap rates down, especially the well diversified and easily understood multifamily sector. Globally, these shifts also occur frequently based on swings in currency rates. For global asset managers, U.S. cap rates relative to cap rates and foreign exchange forward curves in other countries can also drive inflows of capital into the U.S., ultimately compressing cap rates.

     7. Higher Rates but Better Terms: When interest rates rise, borrowers have a reduced incentive to borrow, but lenders have an increased incentive to lend. So, while rates might be higher, lenders may offer higher LTVs, slower amortization, longer interest only periods, reduced underwriting standards, etc. These factors increase the flow of debt and make the debt more advantageous even when rates are rising, driving cap rates down or flat.

▪ Interest Rate & Cap Rate Mitigation: While we at Clear Bay Capital believe cap rates will decrease or remain flat over the next 2-3 years, no one can predict the future and so we are always focused on risk mitigants, regardless of our current market view. With this comes good news and bad news. The good news is mitigating interest rate and cap rate risks is simple. The bad news is mitigating these risks is not sexy. While some deal sponsors may ignore the below time-tested guidelines to allow for gaudy projections, at Clear Bay Capital we take the proven, old fashion route of simply sourcing strong deals that can produce solid returns while still adhering to these principles.

     1. Low Loan to Value: While leverage in the +80%s (and sometimes +90%s!) sure can make deals look good on paper, it creates outsize execution risk. Deals with this much debt are at serious risk of imploding with small fluctuations in cap rates or interest rates. Lower leverage not only allows the deal to weather any unknown storm during the hold period, but it also gives more flexibility when refinancing (see point #5 above regarding debt crises when banks attempt to de-lever their holdings)

     2. Long-Term Debt: when debt matures you are at the whim of the market. In 2008 financial crisis, even strong deals with good cash flow had a hard time finding lenders to refinance. The deals that easily weathered this storm had either low LTVs or didn’t have a debt maturity and were able to ride out the storm. Extension options and long-term debt greatly mitigate cap rate and interest rate risk.

     3. There are several other ways Clear Bay Capital mitigates risk on all our deals, contact us if you are curious to learn more.

▪ Conclusion: While it is catchy, logical, and easy to espouse, it is overly simplistic to assume that rising interest rates will also lead to rising cap rates, and in many cases, it is downright wrong. The numerous macro- and micro-economic factors noted above play important roles in determining the future path of cap rates. Luckily, Clear Bay Capital extensively evaluates these factors along with numerous others when evaluating each deal to drive returns and mitigate risks.

References:

Commercial Search.com – New Study Aims to Crack Cap Rate Code

The Illusion of Correlation between Interest Rates and Cap Rates by Erez Coehn

Understanding the Correlation between Cap Rates and Treasury Yields by BlueVault - Frozen on the Rates: Impact of Interest Rates on Capitalization Rates by Paul Mouchakkaa

Cap Rate vs Borrowing Cost – A 10 Year Review by Quantum Real Estate Advisors

The End of an Era by Robert Hoffman & FS Investments

The Way Forward With Cap Rate Spreads by William Freedman

- The Linneman Letter by Linneman Associates

Interest Rate and Cap Rate Spread Near Widest Ever by Randolph Taylor - Principles for Navigating Big Debt Crises by Ray Dalio

Rising Interest Rates Will not Necessarily Increase Cap Rates by Randal and Matthew Zisler