Interest Rates Rise: Will Cap Rates Follow?

Interest Rates Rise, Are Cap Rates About to Follow?

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In the March Federal Reserve meeting the FED raised their FED funds rate by a quarter of a percent, a second time in the last couple of months. There’s more than one view on interest rates when it comes to real estate investments. On the one hand, a slow and steady rise in interest rates back to a the long term normal range is a signal by the FED that the US economy is improving and getting back to full normalcy after the abnormally long Great Recession and that such overall economic improvements add value to commercial real estate due to rising rents. The other school of thought is that interest rate moves in tandem with real estate cap rates: as interest rates move up so does cap rates, which means that valuation metrics go down.

 

A recent research study by pension fund giant TIAA Global Asset Management, call into question the direct link between the two. Their report found that rising interest rates did not have an automatic move by cap rates. They found very low correlation. “Interest rates and capitalization rates are believed to move in lockstep, with higher interest rates quickly translating into higher capitalization rates and lower property values,” said Tom Park, TH Real Estate, Strategy & Research for North America. “That is not necessarily the case. If interest rates are rising because of stronger economic growth, as is currently the case, real estate demand will also likely be growing.”

 

Maybe both are right to a certain degree, but I would personally put more weight on the argument that there is a long term relationship and I’ll tell you why, but first a couple of caveats. Firstly cap rates are not a published rate that all buyers and sellers adhere to, but an average of valuations from a wide sample of transactions. Those valuations and the underlying economics necessary to establish true cap rates are far being totally accurate, but involve a lot of interpolation. The net income of most properties are typically not of public knowledge and can be subject to interpretation as well.  They are aggregate estimates at best.  Secondly, there is a significant lag time between when a transaction goes under contract and when it closes, often 4-6 months or more. As such there’s a timing disconnect right off the bat between FED rates and cap rates….not an automatic cap rate reset.

 

My real reason for believing there’s more of a connection between FED funds’ rates and cap rate come down to the borrowing costs of real estate investor.  While the FED rate and cap rate argument can be debated, there is no debate on the direct correlation between FED rates and mortgage costs.  As FED rates go up, mortgage rates are definitely going to follow suit.  Whether the two interest rate moves are the same or not will depend on the market’s perception on macro-economic factors so the further out you go the more the disconnect becomes.   You could have rising short term interest rates, but with a lesser rise in long term rates….what is also called a “flattening of the interest yield curve”.  Needless to say the two recent FED rate increases (50 basis point increases altogether) has caused mortgage rates to rise by about the same amount.  When interest rates rise and cap rates don’t, then there is a real squeeze on the positive leverage effect of borrowing and since leverage is a big part of real estate investing for many.  Unless there’s a big enough spread between what the yield (think Cap Rate) of the property is versus what the cost of borrowing will be then leverage can become negative not positive….not necessarily good for the buyer.  Generally there needs to be a 2.5-3.0% spread between these two to offset the effect of principal amortization.  If the lender will agree to a longer amortization period of the loan (more than 20 years) then the spread can be lower.  So if a property can support a 25 year amortization and the spread is around 2.5% then a 4.5% interest rate of six months ago could have support a 7% cap rate, but today the cap rate would have to move up closer to 7.5 to get the same return on investment.

 

One concept that may be a little counterintuitive is that you conceivably can have a rise in cap rates and NOT have a drop in property values. The reason being rise in rental rates.  If the rental income goes up because of a growing economy then you can still maintain a certain property value despite having a somewhat higher cap rate.  Commercial real estate investors like to see some manageable levels of inflation, because inflation typically translates into rising rents which is the biggest thing they need to have to combat a rising interest rate environment. Keep in mind however that real estate is very localized so that a growing economy doesn’t automatically translate into higher rents for your property…that will depend on the supply and demand in your small trade area,  the appeal of your property and so much more.   Unfortunately there are no clear cut answers, just a multitude of factors that you need to consider whether you are a buyer or a seller.

For more commercial real estate insight contact Dougall McCorkle.

Dougall McCorkle
Premier Commercial Inc. – lic. Real estate brokers
239-860-3368
Dougall@premiermail.net

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