How to Make Sense of Where Cap Rates Are Headed

The big takeaway from last week’s meeting of the Federal Reserve appears to be that interest rates will rise next year – and that has many CRE professionals asking if cap rates will also go up. 

But Jim Costello of Real Capital Analytics is asking a different question: why should cap rates start responding to interest rates now all of a sudden?

While Costello acknowledges “there are a number of ways to unpack cap rates, what drives them, and how investors should set expectations around them,” he takes issue with what he calls the most pervasive and simplest approach: to examine 10-year Treasuries, to add the current spread to cap rates to those future predictions, and to then assume that cap rates move up in lockstep.

But “this approach never works as there has never been a one-to-one correlation between cap rates and interest rates,” Costello writes in a recent analysis.

“Talking with acquisition professionals, they like to look at cap rates on deals relative to their cost of financing and are willing to take a narrower spread when they have a higher tolerance for risk,” he says. 

Costello’s research plotting the decomposition of US commercial cap rates shows that during the 10 months of 2020 where the 10-year Treasuries were below 1%, “mortgage rates did not chase interest rates in lockstep,” he notes. “Lenders set a floor and mortgage rates averaged 3.7% over those 10 months, a 300 bps spread to the 10-year US Treasury. In the less turbulent pre-Covid times from 2015 to 2019, that spread averaged 230 bps as lenders were willing to take on more risk. The 10-year Treasury is higher today than it was over most of 2020 but risk tolerance from lenders has brought that spread back down to 230 bps as of August 2021.”

And the spread to the mortgage rate had little impact for equity investors: over that same 10-month period, he says, cap rates posted a 260 bps spread to mortgage rates. 

“Even before the pandemic, equity investors were fearful of the potential for rising interest rates and increased capex costs, and were pricing in these risks with higher spreads at acquisition,” Costello writes.

While the 10-year Treasury has been “abnormally low” for quite some time, Costello has a word to the wise for investors. 

“If we get a fed funds rate closer to 2% and a 10 year Treasury approaching 3%, you should not expect that the current spreads to mortgage rates and cap rates should just stack up on top of that 3% interest rate level,” he cautions. “Those spreads themselves expand and shrink over time based on the different risk perceptions of the participants in the equity and debt portions of the capital stack. If the interest rate increases come about from a scenario where everybody in the market is fearful, those spreads could actually increase relative to recent levels and pricing would be savaged.”

 A more optimistic scenario, he continues, would look at interest rate increases as a function of growth in the economy. To determine where cap rates will be headed, you should really be asking yourself what factors will drive every market participant’s perception of risk.