The Azucena Take: The Correlation Between Cap Rates and Intrest Rates
With interest rates going up, many investors have been wondering if cap rates will be going up as well. This has been brought up because many believe there is a correlation between cap rates and interest rates. The idea is that borrowing costs will drive buyers' decisions, forcing sellers to lower their prices.
Even though there is some merit to the idea, it's far from the truth. Like anything investment-related, there are nuances to everything, and a question can't be answered with a "yes" or "no".
What are Cap Rates?
Before going more into this, it helps to know what cap rates are:
Capitalization Rate (or cap rate) is used by brokers and investors to estimate the expected rate of return that is generated by an investment property. This is calculated by taking the net operating income (NOI) and dividing it by the value of the property.
Formula: NOI / Property Value = Cap Rate
Cap Rates vs. 10-Year Treasury
Even though many feel there is a correlation between cap rates and interest rates, data does not support it. Looking at the 10-Year Treasury, the spread has ranged from 582 BPS in 2010 to 214 BPS in 2006. That is because there is more going on and other factors that are at play. Also, the economic conditions are never the same.
Factors to Consider
To understand what could also be driving cap rates, one needs to consider the following factors.
Active Capital: The availability of capital will always be a driving force when it comes to driving cap rates. For example, cap rates jumped during the 2008 crash due to a lack of available capital in the market. Many don't expect to see the same thing happen in 2022 as there is a lot of capital on the market.
Remember that the Federal Reserve is raising interest rates because of inflation. The ongoing inflation is partly driven by pent-up demand and the easy availability of capital. Currently, there are over $18 trillion in saving accounts and household cash has surpassed household debt for the first time since 1991.
Alternative Investments: With easy access to capital and a surplus of cash saved, many will be looking to invest. Thankfully there are plenty of investment opportunities in the current economy. From the stock market to tech start-ups, investors have plenty of choices. Even in commercial real estate, investors have a plethora of choices that also have the best return on investment.
Examine the return on investments based on asset classes vs. the stock market. If one were to invest in the S&P 500 back in 2001, they will have a return of 416% by 2021. However; if one had invested in multifamily and retail properties, they would have a return of 458% and 461% by 2021. All will also impact the average cap rates in a market.
Upside Potential: Through market momentum or investor value add should bring in more capital (thus bringing down cap rates). For example, industrial properties have seen the biggest net absorption rate in the last 10 years while spiking in value during the pandemic.
Demographics: A shift in market demographics has resulted in a change in demand. Boomers looking to retire will be more interested in a single-tenant retail property on a triple net lease while Gen-X and Millennials will be looking to enter the multifamily market.
What it Means for Investors?
The final thing an investor should consider is that the quality of a cap rate will be different in each market. Many experts will say a cap rate between 5% to 10% is good but that might not be ideal for some markets. The takeaway should be that a smart investor should look at the nuance of everything while also doing the proper research regarding their market.
The Azucena Take provides an inside look into the investment real estate market using the research done and data collected by Marcus & Millichap