Cap Rates Might Finally Start to Rise Again

According to a First American Financial Corporation analysis, cap rates might finally start to recover some of their value. 

The firm’s potential capitalization rate (PCR) model for the first quarter of 2022 “estimates capitalization rates based on the historical relationship between interest rates, rental income, prevailing occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends.”

As the company noted, inflation has stubbornly hung in, rather than being the “transient” phenomenon the Federal Reserve predicted it would be because of pandemic-induced supply chain issues. Eventually the Fed started tightening monetary policy, most recently raising its benchmark interest rates by 75 points, the largest single jump since 1994.

One result was a rise in the 10-year Treasury, which went from roughly 1.7% in early January 2022 to a high of 3.48% when the rate hike happened. The 10-year closed yesterday at 2.97%. Given additional expected quantitative tightening—the Fed allows bonds its holding to reach maturity and then removes them from its balance sheet, which eliminates that extra money it had pumped into the system—First American says that the 10-year yield will likely continue to grow.

The 10-year is seen as a virtually risk-free way of investing and one that investors use to measure the value of riskier investments, including commercial real estate. Another investment will have to now return more to be seen as worth the risk.

“Since capitalization (cap) rates are a measure of return on an asset, higher ‘risk-free’ rates mean sellers will need to reduce their price expectations or increase cash flow, if that’s an option, to entice buyers seeking competitive yields, which should also push cap rates up,” First American senior commercial real estate economist Xander Snyder said in prepared remarks.

Currently, cap rates are still at near-record lows, but the PCR model suggests that slower price growth is likely to push cap rates up. But not all CRE property types are in the same position. “Multifamily and industrial assets set first-quarter price growth records, increasing at a faster rate than any other first quarter in the past 20 years, while office and retail assets were a drag on overall CRE price growth in the first quarter,” Snyder said. “However, a record amount of industrial square footage is currently under construction and expected to come to market later this year, which may slow price growth for industrial assets and put further upward pressure on the potential cap rate as the year progresses.”

In April, First American said that cap rates at that time were poised for further drops, but conditions have been changing.