Higher Interest Rates + Late Cycle = Lower Cap Rates. Huh? For the 22+ years I’ve been in this business, investors have relied on the relationship between cap rates and interest rates. But perhaps it’s time for us to stop relying on conventional wisdom.
The general rule of thumb has been to look at cap rate as a spread over the cost of debt (typically the 10-year Treasury bill or Baa bonds). Given that we have seen a material rise in both long- and short-term base rates (Treasurys/swaps and LIBOR) and given that according to our U.S. Cap Rate Survey H1 2018 cap rates are stable to declining across most asset classes (with tertiary retail a notable exception), investors are asking: “When is this going to start acting normally again!”
The answer is that this is normal, since cap rates are a function of growth expectations and the weighted average cost of capital (WACC), not just the cost of debt. While the cost of debt has gone up slightly, the cost of equity has dropped. The cost of debt also hasn’t gone up as much as the base rates would suggest, due to a combination of spread compression and the entrance of many new players into the marketplace. This is putting further downward pressure on cost, even for riskier loans (bridge, construction), and is shifting borrower strategies, as evidenced by an increase in the percentage of borrowers electing interest-only loans to 22% from 11% over the past year.
It is the equity side where things get more interesting. Unlike the dire predictions about the ability to roll over the so-called CMBS “wall of maturities,” which turned out to be largely unfounded, our industry has not nearly been as focused on the “wall of equity” that has been building since the tech-bubble in the early 2000s. That’s when institutional equity began to wake up to commercial real estate as more than just an alternative investment. Since then, allocations to CRE have jumped from approximately 5% of institutions’ total investment allocations to more than 10% today.
With the increased allocations, there has been a material increase in demand for high-yielding investments commensurate with an increase in the global savings rate to more than 26% today from 23% in the 1980s. That may not seem like a big move, but that money is disproportionately in older hands as established economies are “graying” rapidly and require yield that CRE is well-placed to provide. More importantly, it means that this cheaper-equity trend is durable. While there may be some short-term pullback in liquidity during the next recession that will impact spot-market pricing, the longer-term trend will be lower cap rates indefinitely. So, the cost of debt may have gone up, but the overall cost of capital got “WACCed” down by the decreasing cost of equity.
Although there hasn’t been material across-the-board upward movement in cap rates, this doesn’t mean that cap rates won’t increase in the next year. Our base model indicates that the next recession is about 18 months out (late 2019), but there are several factors that could delay it to 2020 or beyond, including the late-cycle fiscal stimulus of federal tax reductions and the fact that inflationary pressures (particularly wage inflation) seem very tame. As in any recessionary period, interest rates will drop and cap rates will increase due to higher risk premium.
Another factor getting a lot of attention as a marker of when the next recession might occur is a yield-curve inversion, where the rates paid on short-term debt exceed those of long-term debt. This scenario seems more likely today than at any point since the Global Financial Crisis, as the “2-10” spread (spread between the two-year and 10-year U.S. Treasurys) is currently at its tightest level since then. With the Fed expected to raise short-term rates two more times this year and a few next, at least some short-term inversion seems likely. While this has been a harbinger of recessions for decades, there is a significant lagging effect (the yield curve first inverted in December 2005 and the recession didn’t start until late 2007) and the cheap equity tsunami may make this upcycle more durable.
Another implication of increasing supplies of cheap equity is that a recession or yield-curve inversion will not cause as much upward movement in cap rates as might be expected in the past. While some studies suggest a 70-basis-point increase in cap rates for every 100-basis-point increase in the cost of debt, I don’t agree, particularly for high-growth secondary markets that may continue to see cap rate compression in a modestly increasing interest-rate environment. CBRE’s H1 2018 Cap Rate Survey shows exactly this, as cap rates compressed the most in Tier III industrial and Tier II multifamily markets.
Assets have shown peak-cycle cap rate convergence between different market tiers in prior cycles. What is different in this cycle, and making asset allocation decisions based on tier more challenging, is what appears to be more significant movement between tiers. For example, several Tier III markets have moved up to Tier II status (Nashville, Raleigh) and at least two (Seattle, Dallas) have moved up to Tier I with two more on the cusp (Austin, Denver). The traditional definitions of tiers or primary vs. secondary markets are being redefined by newcomers that exhibit outsized growth and enough critical mass/liquidity to attract a deep institutional capital following.
Enjoy our latest U.S. Cap Rate Survey and reach out to our local Capital Markets or Research professionals to learn more!