Cap Rates Too Low? Heck No! Find Out Why

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Cap Rates Too Low? Heck No! Find Out Why


 A Pessimistic Belief Eviscerated

Before you accuse me of “drinking the Kool-Aid,” i.e., having a point of view about cap rates that doesn’t hold up under critical examination, let me assure you that by the time you finish reading this blog post you will at the very least understand my point of view.  You might even be convinced I’m right!  So here goes:

I recently attended the Sperry Van Ness Economic Forum in Salem, Oregon.  One of the speakers was Jim Costello of Real Capital Analytics.  As the name implies, Real Capital Analytics is a data and analytics firm that focuses exclusively on the investment market for commercial real estate.

About half way through Mr. Costello’s presentation he showed us a chart that made me almost get out of my chair with excitement.  It was if a commonly held pessimistic belief was being eviscerated before my very eyes.  Ask almost anyone in commercial real estate these days about cap rates and you will hear concern about cap rates being too low, blah, blah, blah…  Am I right?  Of course I’m right.

The chart he showed that got me all excited is shown below:

Cap Rates Are Relative

Cap Rates vs Adjusted Cap Rates

Let me help explain what you’re looking at.  The chart shows the correlation between cap rates and the ten year U.S. treasury yield.  For the past 15 years apartment cap rates have averaged 319 basis points over the ten year treasury yield (the orange straight line).

But what’s not shown on the chart are what ten year treasury yields have been over the same time period.  We all know what treasury rates have been doing for the past 25 years.  Since 1981, for a variety of reasons we need not elaborate here, they have steadily declined.  So while cap rates are at all-time lows, when these same cap rates are adjusted for declining treasury rates it shows a completely different story.

Notice that adjusted cap rates (the cap rate less the ten year treasury yield) bottomed out in 2006 and 2007 about 120 basis points above the 10 year treasury yield.  This makes perfect sense because that was right before the collapse of the commercial real estate market.  The prices investors were paying for properties back then were at the peak of the Silly-Stupid Phase of the real estate cycle.

And where are cap rates today?  They are about 360 basis points above current treasury yields.  In other words, cap rates today could decline another 40 basis points in relation to 10 year treasury yields in order to get back to the average cap rate spread (319 bps) for the past 15 years!

What Happens When Treasury Yields Go Back Up?

Now I know some of you are thinking, “What happens when treasury yields go back up?  Won’t investors have paid too much for these low cap rate properties?”  Good question.

Assuming your premise is correct, i.e., treasury yields will eventually go back up, there are couple of things you can do today to avoid the brunt of declining property values.

  • Lock in long term interest rates
  • Don’t overleverage your properties

A property’s cash flow before debt service will not be affected if values plummet.  Right?  The only thing that has the potential of being adversely affected is the property’s mortgage payment.  Those who lock in long term interest rates will have the benefit of fixed mortgage payments at excellent interest rates for a long period of time.  And those who modestly leverage their properties will have a much better chance of weathering the economic upheaval that will occur if interest rates rise precipitously.  So if you believe it’s inevitable that treasury rates will rise over time, now’s the time to either lock in a very favorable interest rate for as long as possible or make sure you’re not overleveraging your property.

Why Treasury Yields Will Not Rise

But I believe your initial premise is likely wrong.  I don’t see interest rates rising to previous levels for two reasons:

  • The central banks of the world, Japan, Switzerland, and Europe, are currently toying with negative interest rates to stimulate their economies. I don’t believe the U.S. can raise interest rates when everyone else is lowering theirs.  There would be too many unintended consequences globally to let that happen.
  • Can you imagine what would happen to the annual interest on the national debt if rates were to rise even modestly? It would likely put the federal government in default.  If the treasury yield were to rise to 5% it would add another $900 billion in annual interest to the federal budget.  That would be catastrophic.  The Federal Reserve would not allow it to happen.

So are cap rates too low?  Heck no!

Sources: Low Cap Rates?  It Is All Relative, Jim Costello speech, Real Capital Analytics, https://www.rcanalytics.com/, February 22, 2016; Can a nation $18 trillion in debt afford higher interest rates & will that change retirements? By Daniel R. Amerman, CFA, www.danielamerman.com


3 Comments

  1. Rennie Gabriel April 4, 2016 at 4:23 pm - Reply

    Thank you for the perspective and the advice to get long term rates and do not overleverage.

  2. Wes Hill April 7, 2016 at 8:13 am - Reply

    Insightful.

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