The Federal Reserve has increased the federal funds rate several times in 2022 from zero percent in March of this year. This has been the fastest rise in the funds' rate ever and has begun to impact the CRE market. The public REIT stocks have already corrected with the FTSE-NAREIT All Equity Index down 27.93% through September 2022. Higher interest rates and a slower economy have revalued public REIT prices but not private commercial real estate values. Rising risk-free rates increase the weighted average cost of capital and when a company's free cash flow is discounted at this higher cost of capital, the value of the company and its stock declines. The private CRE market is at a standstill and there are few transactions due to the large and widening bid-ask spread of property values. Therefore, private CRE values have not been corrected in line with the public REITs, and it may take another nine months to a year for these values to reprice lower.

Let's say the 10-Year T-Bond rate is 4.0% as it was earlier this fall. With this higher risk-free rate, an average cap rate can be calculated from the cap rate formula, which is the risk-free rate based on the 10-Year Treasury of 4.0% plus a risk premium of 6.0% less the growth in rents of 3.0% or a cap rate of 7.0%. This is a general cap rate and needs to be further adjusted for the property type and location. However, a minimum cap rate for even the booming industrial market should be 5.0%-7.0%, and not the 3.0% to 5.0% currently in the market and for apartments cap rates should rise to 5.50% to 7.50%, versus 4.0% to 6.0% currently in the market.

Whenever there is a downward price valuation in real estate or any private asset, the sellers are usually behind the curve as there is not a public market to mark the asset to market on a daily basis like a public REIT. Many sellers still believe their new credit tenant leased industrial property and Class A apartment they bought at a 3.5% cap rate a few years ago, can be sold at the same return. A seller will typically put a property on the market at the 3.50% cap rate, but all potential buyers will be offering a price based on a higher return of 6.0% or 7.0%. This will be a sticker shock to the seller. The seller will in many cases, take the property off the market, in anticipation of the good old days of sub-4 % cap rates returning, and continue to own and manage the property. I doubt those days will return anytime soon. The good news with higher cap rates is for buyers of CRE. There are currently more than $200 billion in private real estate funds in the U.S. looking for deals. These buyers will enjoy the opportunity to finally buy good real estate at a reasonable risk-adjusted cap rate.