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The Connection Between Interest Rates and Capitalization Rates

The correlation between real estate cap rates and Treasury rates is quite tenuous. In fact, there are multiple variabl

The Federal Reserve’s Quantitative Easing (QE) program initiated in 2009 has brought about an unprecedented low interest rate environment and a simultaneous run of very strong returns in the commercial real estate space. With the culmination of QE now announced and the reality sinking in that Treasury rates might move upwards, investors are pondering the impact on their portfolios. Real estate is not immune from this discussion.

A key metric in real estate valuation is the capitalization rate, or cap rate. The cap rate is essentially similar to a yield for a bond, or the inverse of a price-earnings multiple in equities, in that it compares the net operating income of the property to the overall value. Many investors have been laser-focused on how a rise in US Treasury rates could trigger a rise in cap rates, and therefore a fall in real estate values. But will it?

Everyone assumes the answer is yes, given that the 10-year Treasury rate generally serves as a de facto baseline for expected returns. But the commercial real estate market does not march to the beat of just one drum. Upon close technical analysis, the correlation between cap rates and Treasury rates turns out to be tenuous. In fact, there are timing disconnects, lags in appraisals and other variables that influence the bond market and the real estate market very differently. And the fact that Treasuries have enjoyed a 30-plus-year bull market, and interest rates have been on a long downward trajectory, adds to the challenge of understanding the impact of Treasury rates on cap rates. Significantly, there have been several occasions when cap rates did not move in sync with interest rates.

This suggests that other key variables may influence cap rate movements, including credit availability, supply-demand dynamic of space markets and inflation.

The effect of credit availability, and the importance of commercial real estate mortgages to valuations, cannot be overstated. Currently, US banks have shown an increased appetite for real estate lending. The commercial mortgage-backed securities market has revived. Risks, however, remain: Construction loans are still difficult to obtain and credit can vanish quickly, as happened during the global financial crisis.

The second key variable is the supply-demand dynamic. Supply gluts and/or falling demand can lead to a rise in cap rates regardless of what Treasuries are doing.

Inflation represents the last of the variables. Real estate may offer protection against rising inflation, mainly in the form of higher cash flow from rents or income.

The current environment, where credit availability is growing, construction lending remains muted and demand is outstripping supply, may mitigate or even potentially offset any rise in cap rates. Thus, a singular focus on Treasury rate movements to the exclusion of other key explanatory variables may lead to sub optimal investment decisions.

Click here for the full research report, “Frozen on the Rates: Impact of Interest Rates on Capitalization Rates” or explore more Ideas from Investment Management.