Dropping Cap Rates Boosts CRE, Real Estate Debt

Falling yields on investment-grade bonds are bolstering the case for real estate as an attractive investment, despite current market challenges. A recent report from Colliers found that cap rate spreads to BBB-rated bonds have fallen by nearly one percentage point below their historical averages across all asset classes. This decline in spreads, along with the relative stability of cap rates in the second quarter, is making commercial real estate a more appealing risk-adjusted option than low-end investment-grade bonds.

Investors use the spread between cap rates in commercial real estate and BBB-rated bond yields to gauge which asset class offers better risk-adjusted returns. Commercial properties with tenants and BBB-rated bonds both carry default risk, allowing for a comparison of their risk profiles. However, price discovery is simpler for fixed-income assets, which trade more frequently in open markets than commercial real estate. A wider spread suggests real estate is priced for higher risk-adjusted returns, while a narrowing gap may indicate that bonds are viewed as safer or more desirable in the current market.

Colliers’ research director for U.S. Capital Markets Aaron Jodka said investors should pay close attention to the spread between yield-producing assets like real estate and bonds as the Federal Reserve prepares to cut interest rates.

“Over the past year, cap rate spreads to BBB bonds have generally tightened,” Jodka said. “Multifamily, which previously had a negative spread, is now positive, while industrial has moved the most, up 0.8 percentage points. Retail also saw an increase, while office has remained largely stable due to recent cap rate compression tied to trades of lower-occupied properties.

“All asset classes now have spreads below long-term trends dating back to the early 2000s and the pre-pandemic era of 2016-2019.”

“Since the end of Q2, BBB bond yields have fallen about 0.6 percentage points as bonds rallied, while cap rates have remained relatively stable,” Jodka said. “This has made commercial real estate more attractive to investors. One could argue that the maturation and expansion of commercial real estate as an investment class should lower spreads compared to historical norms due to the wider availability of capital and competition.”

Colliers’ report comes as real estate credit investors begin observing similar trends. According to a report from KKR, real estate credit currently offers wider spreads and higher yields compared to BBB-rated bonds. With property values declining and lending conditions tightening, the attractiveness of real estate credit is underscored by spreads relative to corporate credit remaining elevated, KKR said.