Interest Rates, Cap Rates Don’t Move in Lockstep

December 16, 2015

Last Updated: December 15, 2015

By Paul Bubny | National | Globe St

NEW YORK CITY—The monthly meeting of the Federal Open Market Committee that gets underway on Tuesday is expected to begin the long-awaited, long-delayed process of normalizing interest rates. With the prospect of near-term action by the Federal Reserve, “real estate investors are worried,” as a new report from TIAA-CREF Asset Management puts it. A specific concern is the effect of rising interest rates on cap rates and valuations.

“Investors’ fears tend to focus on the arithmetic showing that rising interest rates result in increasing cap rates and, all else equal, declining property values,” according to the TIAA-CREF report. “The problem is that the relationship between interest rates and cap rates is more complex and typically, all else is not equal.”

Historical data show that cap rates and 10-year Treasury yields don’t necessarily move in lockstep. More importantly, the report says, the data show that changes in Treasury yields don’t necessarily result in changes in cap rates. “Even assuming lags between interest rate and cap rate changes, analysis found no statistically significant relationship between the two variables,” the report states.

Cap rates are influenced by “a wider network of variables beyond interest rates,” including real estate fundamentals, capital flows and investor risk appetite. Thus, the impact of rising interest rates on real estate performance is difficult to predict, according to the TIAA-CREF report. “Indeed, the outlook for real estate in a rising rate environment depends on a variety of factors specific to the current and expected economic and property market environments.”

While the report acknowledges that fears that the eventual rise in interest rates will result in higher cap rates and declining property values “seem reasonable,” in fact these anxieties “oversimplify and ignore variables that have the potential to offset value declines.” It cites a number of factors that can protect overall property performance in a rising interest rate environment, such as the spread between cap rates and 10-year Treasury yields.

The current cap rate spread, for instance, is just over 300 basis points, about 30 bps higher than the long-term historical average of 270 bps. “The extra spread can absorb a small increase in 10-year Treasury yields and/or a further reduction in cap rates before property values are affected,” according to the report, and therefore can be seen as a “a slight protective buffer” from the expected rise in interest rates.

Another factor is the expected drop in unemployment to below 5% in 2016 as the economy continues to strengthen. “The expected economic and jobs strength has positive implications for real estate occupancies, rent growth and NOI growth,” according to the TIAA-CREF report. “These factors can help offset, at least partially, any adverse price impacts of rising cap rates.”

TIAA-CREF also sees some protection in common underwriting practices. Property valuations usually assume a holding period increase of 50 to 100 bps in the cap rate over the initial acquisition rate, and therefore cap rate increases are typically accounted for in return expectations. Accordingly, he report says, “investors should not fear cap rate increases that they expect, only the ones that they do not anticipate.”

The timing of cap rate changes also has an effect. “In the near term, cap rate increases can have a dramatic impact on property performance,” the report states. “Yet real estate performance is less sensitive to cap rate changes as the investment horizon lengthens. Time has the potential to heal most, but likely not all, wounds from rising cap rates through the magic of compounding annual NOI growth rates.”

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John E. Moriarty, ChFC
December 2015
February 3, 2016

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