Why Rising Interest Rates Won’t Lead to Cap Rate Change
With both inflation and interest rates rising, following the first Federal Reserve rate hike in three years, many people have no living memory of what can happen—for example, the double-digit rate mortgages that the 1980s saw.
For CRE professionals, the question to ask is will the coming increases mean a change in cap rates? According to JLL chief economist Ryan Severino, the answer is that the two have a poor correlation.
“More than 40 years of empirical evidence supports this view,” he writes. “The poor correlation exists at both the short end of the curve with the fed funds rate and at the long end of the curve with longer dated Treasury yields.”
Severino points to what he calls the “three fundamental components of cap rates,” which are the risk-free rate proxy, change in net operating income, and pure risk premium.
The risk-free rate (RFR) is the rate of return an investor should be able to get without facing risk. Treasurys are generally considered a proxy for the theoretical value because of the assumption that the US will not default. Although often the RFR proxy for investing is the three-month Treasury rate, Severino notes that the ten-year is more commonly used in CRE.
NOI and cash flows affect the price of real estate because they contribute to the more complete financial state of properties. Then the pure risk premium is investor sentiment.
One simple explanation is that interest rates are only one factor that affect cap rates. Depending on the other two factors, it may have a significant influence or not.
Severino goes into more detail, noting that interest rate increases usually mean a positive economic outlook, which does mean higher inflation but also more cash into equities and CRE (which is often seen as an inflation hedge).
Also, “space market fundamentals benefit when economic growth is accelerating” and nudge NOI and cash flows upward.
“Of course, investors are smart enough to recognize the improving environment, so their pure risk premium unsurprisingly tends to compress when they feel more optimistic about the outlook for the economy and the CRE market,” Severino writes. “Therefore, these two components of cap rates positively correlate and effectively work together to push cap rates down when the macro outlook is improving/positive and interest rates are rising.”
Right now, the Fed is limited on how much or how quickly it can raise interest rates because it doesn’t want to trigger a big slowdown, or a recession as structural economic growth has slowed. But while NOI, cash flow, and investor sentiment remain strong, cap rates, Severino thinks, are unlikely to expand.