Cap and Interest Rates Face Off on a Collision Course

By Patrick Nutt, Calkain Cos.

History has shown that the spread between cap rates and the Treasury yield should thin out, but as we've seen, that compression will most likely be the move of both rates.

With both cap rates falling and interest rates rising, just how much lower can the spread between these two figures go before investors begin to push back? Consumer confidence has crept back to relatively normal levels, lowering demand for safe-haven U.S. Treasury bills and subsequently driving the yield in an inverse direction. Commercial real estate seems to have bottomed out. Cap rates for net lease investments stabilized in early 2010 and rapidly compressed over the following 12 months. As the economic world has changed over the past few years, rates and their relationships have changed as fast as dollar-store concepts are expanding.

It should come as no surprise to those actively in search of top-tier assets over the past year that cap rate compression is very real. According to Calkain’s fourth-quarter 2010 cap rate report, net leased cap rates fell anywhere from 50 to 125 basis points during 2010, depending on asset class and sector. Walgreens, often used as an industry barometer to gauge the overall world of cap rates, were realizing average cap rates near 8 percent as of the end of 2009. However, as 2011 unfolds, transactions for new construction Walgreens are now nearing the 7 percent mark, with those assets in highly desirable geographic areas trading in the upper 6 percent cap rate range. As we dissect these transactions to evaluate the driving factor pushing cap rates lower, the most apparent cause is the basic economic principle of supply and demand.

On the demand side, there has been a rise in activity from private individuals searching for safe, passive investments, while turmoil abroad has boosted the flow of foreign capital into U.S. assets. At the same time institutional-class investors, such as public and private REITs, are raising funds as fast as they can place them. Conversely, the supply side of the equation has shrunk drastically. As the recession sunk in, tenants commonly occupying these net leased assets contracted, closing underperforming stores and choosing remodeling existing locations over expanding into new sites. According to research from the International Council of Shopping Centers, the U.S. shopping center industry grew at its slowest pace in 40 years, expanding just 0.2 percent in comparison to 2006 growth of 3 percent. While discount retailers such as Dollar General continue to expand, other perennial net lease tenants remain hesitant. Even Walgreens lowered their 2011 openings to just 50 percent of their 2010 figure. All signs point towards a general lack of supply throughout 2011.

While cap rates were falling, many speculated on the potential negative ramifications as benchmark 10-year treasury yield rose rapidly, gaining 75 basis points in the last two months of 2010. As of early February, that rate has increased another 25 bps to 3.65 percent — the highest level since early 2010 – however we continue to remain at historical lows across the board. Consider this, from July 1958 until the beginning of the recession in 2008, there has only been a two month period of time where the 10 year U.S. Treasury provided a lower yield than today. In short, even with the recent rise in the yield on the 10 year note, over the past 50-plus years that yield has been higher than where it stands today 98 percent of the time.

There will always be a gap between yields for “risk free” investments, such as the 10-year U.S. Treasury and alternative assets, such as net leased properties. Efficient markets utilize this higher yield or spread to price risk into an investment. Historically, the risk premium for retail real estate assets hovers around 410 basis points according to Real Capital Analytics.

However, this spread has recently peaked at 540 basis points. As net leased assets fall under a more conservative, risk averse classification, they observe a lower risk premium. Calkain’s Cap Rate report measures the current spread for net leased assets, as of the end of 2010, near 470 basis points. The risk premium has continued to shrink as cap rates continue to fall, pushing closer to the historical norm. However, they remain a far cry from the 250 basis point spread observed at the peak of the market in 2007, when 10 year US Treasury yields varied between 4.10 percent to 5.10 percent and average cap rates were in the low to mid 7 percent range.

History has shown that the spread between cap rates and the treasury yield should thin out, but I think as we’ve seen, that compression will most likely be the move of both rates. Average cap rates continue to compress due to general lack in supply and treasuries will level out somewhere in the 4 percent range as the economy begins to heal and move forward.