How Will Cap Rates Behave When Interest Rates Jump?
- Nov 19, 2014
This question, of course, is loaded heavily by the increasingly debatable assumption that interest rates indeed will rise in the near future. Yet for the sake of discussion, let us accept the premise that the Fed will soon engineer a modest uptick in, among other rates, the 10-year treasury. Let us further presume that this increase will come as a result of improved employment and a return to healthy inflation growth.
Dime-store wisdom tells us that cap rates will move closely with interest rates, reflecting a simple premium for real estate over treasuries. Reality, however, has proven far more complex. To make sense of this dysfunctional relationship, economists have expressed cap rates in various algebraic terms that can be summarized as follows:
Cap Rate (R) = 10-year treasury (T) + Operating Risk (O) + Liquidity Premium (L), or R = T + O + L.
(For simplicity, this formula intentionally omits an expression of inflation and long-term cash-flow growth expectations, both of which are less impactful factors.)
Restated, R – T (the “Spread”) = O + L. In other words, the spread between treasuries and cap rates is largely a function of two key variables: 1) the near-term supply/demand ratio in a given market, and 2) a premium for (il)liquidity.
The former is easy enough to understand—operating risk will fluctuate with changes in construction activity and demand for rental space. If improving employment rates and upward price pressures result in increased interest rates, often these same forces will drive demand for, say, apartments or warehouses. The improved economic conditions that spur interest rates can simultaneously reduce operating risk, thereby suppressing any cap-rate decompression that otherwise would occur.
Picture a girl holding a balloon while walking up a ramp. The girl represents the economy, the ramp is the 10-year treasury, and the balloon is a given cap rate. If the girl pulls down on the balloon while walking up the ramp, the balloon (cap rates) will move forward but not move up. Many of the factors that propel the girl up the ramp (better jobs, increased household formation, personal consumption) also tend to pull down on the balloon—all at the same time.
But Operating Risk is not the whole story. Our other variable in the Spread—Liquidity Premium—may be more important than Operating Risk. According to economist Dr. Peter Linneman, changes in L are a primary factor in cap-rate changes over time. L is an expression of the availability of capital to invest in real estate: when capital is pricey and scarce, the liquidity premium rises. Conversely, when money is cheap and plentiful, the liquidity premium drops.
Regression analyses by Linneman suggest that, all things being equal, cap rates will rise and fall with capital market liquidity. Furthermore, Linneman found that a 100-bp increase in 10-year treasury yields caused a double-digit basis point cap-rate increase in only one sector: office. Notably, apartments proved the least sensitive to jumps in GDP growth, which drove up cap rates in other sectors.
Bottom line—cap rates do not move in lock-step with interest rates, and there is considerable variation between sectors within real estate, due to differences in construction cycles, lease duration and demand drivers. It is quite possible that cap rates in some markets could continue to compress while interest rates rise gradually over the coming months, especially where supply is truly constrained and capital continues to chase deals.
 Linneman Associates, The Linneman Letter, Volume 14, Issue 2, Summer 2014