Daniel Calano, Prospectus, LLC

Two weeks ago in a special section for real estate Counselors, I reviewed some of the reasons why an interest rate rise might not impact a cap rate rise as much as we would presume. Since cap rates are typically based on interest rates plus risk perception, a direct correlation would seem reasonable. What makes investors nervous is that, an interest rate rise not only costs the property more to operate, but in potentially raising cap rates, causes the value to go down. The logic of the formula is the higher the cost of owning, the less the return on investment, and the less the investor will pay to purchase.

In the past article, I summarize a number of other issues that could decouple the relationship between interest rates and cap rates. The notion was that with an interest rate increase, it is possible not to incur a cap rate increase, thus leaving valuation the same. But there were logical arguments, and research, to the contrary.

Most of the reasoning had to do with an improving economy. Since cap rates are affected part by interest rate and part by risk perception, as the economy improves and risk worry declines, interest rate rise might be accommodated without changes in cap rates or valuation.

Other reasons focused on our global economy. The world is awash with cash seeking yields. U.S. real estate is becoming more in demand by increasingly wealthy foreign countries. Obvious examples are Chine and Russia, but parts of India, South America and others are also significant. For a number of reasons, foreign investors may well be satisfied with lower yields than American investors. Thus, they will buoy demand, increasing prices, keeping cap rates low. Particularly with the amount of government upheaval and ensuing wars, foreign investors are very motivated to seek safe havens. Above all, the United States is that place, and thus real estate assets will continue to have high demand despite increase in interest rates.

I reviewed the research going back several years to see if the correlation between interest rate and cap rate has actually ever decoupled. For the reasons summarized above, as well as some others, the research has quantitatively shown that such periods have existed. Cap rates do not necessarily move in lock step with interest rates, and thus a rise in interest rate may not necessarily change real estate valuation. If we are in one of the periods, this will put investor’s minds at ease.

Research by these groups, Reis, Morgan Stanley, and Teachers Insurance and Annuity Association (TIAA) Research Group, quantitatively shows as much negative correlation between interest rates and cap rates as much as there is positive correlation. They cite that five out of eight periods of rising interest rate since 1990, cap rates have actually declined. Morgan Stanley states that “the connection between cap rates and interest rates has been historically loose”. Their conclusion is that interest rate fluctuation is less significant than other market forces such as those discussed above. They go on to say that cap rates cannot be viewed in a vacuum as only being driven by changes in U.S. treasury rate, and that other variables such as credit availability and the supply/demand dynamic can mitigate or potentially offset any rise in cap rates. TIAA Research Group advises us to keep calm and carry on. They state that the eventual rise in interest rates will not necessarily result in higher cap rates, and resulting declining property values. And, this relationship over simplifies other factors that can offset value decline.

In conclusion, real estate markets do not march to the beat of just one drum. A predominate amount of research shows that, with small interest rate increase such as suggested by the Fed, cap rates will not be significantly impacted. The rate increase will most likely be mitigated by strong economic growth, high demand for safe haven investments, belief that rents will rise, and available credit. While there will ultimately be some impact, the pace of impact will be slow, investors can adjust by “laddering” debt, combining cheaper short term and/or floating rate financing with longer term debt. This will be particularly relevant in large portfolios where asset type and value is spread.

The research presents a compelling case not to worry. But it also hedges, indicating that during certain periods, and certain geographic areas, with variation in a global context, things can change. There have been certain times of correlation between interest rate and cap rates. Further, dramatic changes in interest rate will have a more dramatic impact. REIS summarizes their work by saying “even if interest rates rise, real estate valuations may enjoy some breathing room before assumptions about exit cap rates need to be revised…but shrewd investors should question where cap rates will be 4-6 years from now”. The question still remains that, since the Fed felt that growth and stability would be fostered by keeping rates low, it thus perceives some risk in moving rates higher. Time will tell and more to come.

Daniel Calano, CRE, is the managing partner and principal of Prospectus, LLC, Cambridge, Mass.