The Battle Between Secular Elephant and Cyclical Bear Heats Up

Twenty years ago, cap rates in major European markets were consistently 200 to 300 basis points (bps) lower than those in the U.S. While many local-market-specific factors contributed, the big global reason for the disparity was that the flow of money across the world and the influx of institutional capital to the real estate sector was still in its infancy.

Fast forward to 2018: The world is awash in institutional capital and real interest rates (after adjusted for inflation) move in lockstep around the world more than ever before. This secular shift has put downward pressure on interest rates and cap rates, particularly in larger markets that have institutional or global appeal. This “wall of money” is like an elephant on one end of the cap rate scale and, based on recent allocation announcements, likely will increase and continue to exert downward pressure on interest rates and cap rates.

On the other end of the scale sits the cyclical grizzly bear of inflation. Inflationary forces remind me of a disco ball, since we haven’t seen too much of either of them since the 1970s. I’m sure you have noticed that inflation has picked up in the last few weeks, which led to a U.S. stock market correction in early February, and the 10-year Treasury bill is now 80 bps higher than in September. We know why interest rates are creeping up in the U.S., led by an extremely tight labor market (wage inflation) outlook and increased business and consumer optimism due to corporate tax reform and a stock market that surged 31% last year.  The debate we all are now having is what is going to happen to cap rates because of it.

Some studies have shown that cap rates can increase by as much as 70 bps for every 100 bps rise in interest rates in a lagging effect that can take up to 18 months to fully adjust. Whatever the past link between interest rate and cap rate movement, the weight of the secular capital-wall makes the correlation less pronounced today, though, at the moment, late cycle factors (diminished NOI growth expectations) add additional weakness to the cap rate outlook.

The capital wall—while strong and pushing institutional and international capital further out on the market spectrum—is still disproportionately focused on major markets. This means we may see slightly upward movement in cap rates in secondary markets, which have less institutional backing and more reliance on debt capital. High-growth secondary markets will fare better, as a big part of any potential upward pressure on cap rates will be counterbalanced by stronger NOI growth expectations than other markets.

CBRE’s line of business leaders and capital markets professionals are reporting an increase in re-trade activity (the standard buyer playbook in a rising interest rate environment). This is similar to the reaction to the interest rate spike following the 2016 presidential election, but this time, anecdotally if not yet empirically, we are seeing select seller capitulation, based on sector and geography.

So here is the bottom line: CBRE Research expects to see cap rates either flat or slightly up, contingent on the degree to which interest rates increase. The wall of capital will keep any potential rise very small and the impact mostly felt in weaker secondary markets with less appeal to institutional and international investors. The inflationary grizzly bear is likely to roar louder in 2018, but, as we saw with the spike in early 2017, can quickly crawl back in its den.

By Spencer Levy, Americas Head of @CBREResearch | Senior Economic Advisor

To download the latest CBRE North America Cap Rate Survey click here.