New Study Aims to Crack Cap Rate Code

The model is based on the unemployment rate and the flow of commercial mortgage debt, metrics that are a proxy for U.S. economic performance and capital flows into commercial real estate.
Paul Fiorilla, Director of Research, Yardi Matrix

Forecasting the direction of property yields has long been the Holy Grail of commercial real estate research—although many have tried, finding a solution has been elusive—but a new study purports to have an answer.

Dr. Peter Linneman of Linneman Associates and Matt Larriva, vice president of research and data analytics at Chevy Chase, Md., property firm FCP, believe they have devised a methodology that accurately forecasts acquisition yields up to a year into the future. The model is based on the unemployment rate and the flow of commercial mortgage debt, metrics that are a proxy for U.S. economic performance and capital flows into commercial real estate.


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“We clearly find that an increase in mortgage debt as a percent of GDP drives down cap rates, and an increase in unemployment slightly drives up cap rates,” Linneman and Larriva wrote in the fall issue of “The Linneman Letter,” a quarterly publication on industry trends. “And this stands to reason, as these two variables provide insight to the risk side and the demand side of pricing.”

Using their model, Linneman and Larriva project a modest decline in cap rates over the next one to three years, based on debt market stability, strong capital flows and a recovering economy. “Multifamily cap rates should trend downward for a few reasons, namely the stability of mortgage debt as a percent of GDP, the global search for yield, and potential sector rotation,” Larriva said.

Weak Connection to Interest Rates

Forecasting property acquisition yields, commonly called “cap rates,” is a key part of commercial real estate investing. The goal is to buy when yields are high (and property values are low) and sell when yields are low (and property values are high). The modern investment era was kicked off by the bulk purchases of discounted real estate from the Resolution Trust Corp. some three decades ago. Investors buying the remnants of failed thrifts bought low, rode the recovery up and amassed fortunes.

Forecasting the direction of prices requires determining which metrics cause property prices to change. There are a slew of economic indicators and property fundamental metrics from which to choose, but the correlation between most variables and property yields is not consistent.

One common metric that is often thought to correlate with cap rates is interest rates. To determine whether properties are fairly priced, many in the industry look at a simple time series graph mapping the average cap rate and the 10-year Treasury. Over the last two decades, that gap between those two has averaged just over 300 basis points, but the number has bounced around.

The connection is intuitive. Profit is on some level a function of the spread between the 10-year Treasury yield and the cap rate. The 10-year Treasury, the risk-free rate, is the instrument off which mortgages are priced. On an oversimplified level, owning a property with a 6 percent yield and a 4 percent mortgage yields a 2 percent profit.

Treasury yields have been on a slow march downward since they exploded into the teens in the 1970s. While the market has come to terms with low rates, during much of those years a significant number of market players believed that rates were going to return to some higher and more natural level, which prompted numerous studies into the relationship between interest rates and cap rates.

As it turns out, studies demonstrated that the connection is weak. For example, a 2011 paper by Philip Conner, then a principal at Prudential Real Estate Investors (now PGIM), found that during six periods of rapidly rising interest rates between the late 1970s and the global financial crisis in 2010, cap rates usually remained flat or decreased. “Treasury yields typically rise during periods of economic growth and expanding employment, which serve as a catalyst for improving space market fundamentals and increasing risk appetite,” Conner wrote. “The compression in corporate bond yield spreads during five of the six periods illustrates how investors’ appetite for risk changes when long-term rates are rising.”

Key Pricing Variables

To find correlations that would predict forward-looking pricing, Linneman and Larriva looked at many variables before eventually settling on the unemployment rate and the flow of funds. Unemployment reflects total economic activity. Job growth is a major driver of demand for commercial space. Having jobs enables individuals to form households to rent apartments, use services that form the basis for office employment, buy goods in shopping centers that produce demand for retail and industrial space, travel and spend on leisure and hospitality, and so on.

Mortgage debt as a share of GDP reflects more technical capital markets factors in commercial real estate. Rising property values create demand for increased amounts of debt—if the loan-to-value ratio is constant, then higher property values produce more debt. What’s more, mortgage debt as a share of GDP reflects the sentiment of investors. In the run-up to the global financial crisis, investors and lenders were confident that future cash flows would continue to grow. As a result, buyers of property were willing to accept lower yields (or cap rates), pushing values higher, at the same time lenders were willing to provide increasingly higher levels of leverage.

The result was an explosion of mortgage debt. Mortgages (commercial and residential) increased as a share of GDP from about 60 percent in 2001 to about 100 percent in 2010, according to Linneman and Larriva. The growth proved unsustainable—too much debt caused the market to crash, ushering in a recession and financial crisis with a huge increase in mortgage defaults.

Property values rose the leverage boom up—and down. Asset values dropped about 25 percent on average between 2008 and 2010, while mortgages as a share of GDP dropped to about 75 percent by 2014 and have remained stable since then. After spiking during the financial crisis, cap rates fell to historical lows in 2015 and have remained stable. According to Green Street Advisors, apartment cap rates averaged 4.7 percent in 2015 and are currently 4.3 percent, while office cap rates fell to 5.0 percent in 2015 and are now 5.4 percent.

The Linneman/Larriva study found that when mortgage debt grows by 1 percent faster than GDP, multifamily cap rates fall by 22 basis points and office cap rates fall 65 basis points. If debt grows by 10 percent relative to GDP, cap rates stand to compress by 220 basis points for multifamily and 650 basis points for office.

Rosy Outlook for Multifamily, Office

Despite the short-term bump in unemployment and a short-term spike in mortgages as a share of GDP due to the pandemic effect in the second quarter of 2020, the Linneman/Larriva model forecasts that cap rates in the sectors studied will be stable, with a drop of 10 basis points in multifamily and 20 basis points in office over the next year.

The steady forecast emanates from the expected stability of mortgage debt as a share of GDP and strong investor demand for commercial real estate. “There’s robust demand for the product, so I’m inclined to think that it will stay well bid,” Larriva said. “Globally there’s record levels of money chasing negative yield. I can see (pension funds) searching out other stable assets that have positive yields, like institutionally owned/operated multifamily real estate.”

Potential headwinds for the rosy forecast include a change in inflation or growth in forbearance due to economic turbulence caused by COVID-19. To date, loan delinquencies have been concentrated in retail and hotel loans, but multifamily and office could see a jump in loan defaults if conditions worsen. As of November, CMBS delinquency rates were 3.1 percent for multifamily and 2.3 percent for office, far below the 19.5 percent for hotel and 14.3 percent for retail, according to Trepp.

Inflation—currently at 1.2 percent and well below the Federal Reserve target of 2.0 percent—could be a double-edged sword for commercial property if it rises. That could eat into property values, but also would make the 4-6 percent yields on commercial real estate attractive to investors, Larriva said. A bigger potential headwind is deflation, which would portend a slowing economy.

Any scenario will not have the same pricing impact on each property type. Work-from-home measures, closure of stores and reduction in travel stemming from COVID-19 are producing disparate impacts on each property type. Multifamily, industrial and single-family rentals could benefit from capital re-allocated from other property segments, Larriva said.