What Else Drives Cap Rates Besides Rising Interest Rates

Many investors assume a direct correlation between cap rates and interest rates – that borrowing costs will drive investor purchase decisions, and that sellers need to lower prices and raise cap rates as a result.

But while there’s some truth to that, according to Marcus & Millichap’s John Chang, “that doesn’t completely hold true.”

Looking at commercial real estate in general, the spread between the average cap rate and the 10 Year Treasury has been as low as 214 basis points, he said⁠—and “there’s simply a lot more going on in CRE than underwriting to a spread over the cost of capital,” Chang says. 

Other factors matter, according to Chang, including how much capital is active in the market.

“When there’s a shortage of capital, cap rates tend to rise and the yield spread tends to widen, but where there’s a lot of capital, both equity and dent, the spread tends to tighten,” he said.

That’s what’s going on in the current climate. Last year, there was a record number of CRE sales, with the total number of transactions up 30% over 2019 levels. And first quarter numbers suggest the deal flow has continued, with sales up 20% year over year.

“When there’s a lot of liquidity, investors are willing to take a lower yield because they’re competing to invest capital,” Chang said.

Another catch is whether there are alternative investments that offer a better yield, like the stock market or bonds. Chang predicts that given the recent fluctuations in the stock market, more capital may pursue the stable returns offered by commercial real estate. That would keep cap rates lower.

Demographics also count: as baby boomers retire, they’re looking for eligible cash flow, like single-tenant net lease. (Think retiring investors leveraging 1031 exchanges.)

Chang says we may see some upward movement in cap rates, particularly with property types that saw big upticks in value over the last year—but a broad-based reindexing is unlikely.

“Ultimately, real estate yields are about a lot more than interest rates, and investors need to consider all the variables,” he said.

Research from First American Financial Corporation has suggested that cap rates could drop even more as investors battle to own CRE income streams, but the firm has also said cap rates could be reaching a cyclical bottom. In the last quarter of 2021, the actual cap rate hit 5.2%, a record low, but the potential cap was 4.4%. That means property price growth might still top income growth.

“The potential cap rate, as supported by market fundamentals, may be as low as it can go,” Xander Snyder, senior commercial economist at First American, said in prepared remarks. “However, since the actual cap rate remains above the potential cap rate, the actual cap rate could still go even lower as CRE investors compete with each other for the income streams that commercial real estate provides.”

An analysis from the National Association of Realtors has concurred in its own analysis, saying cap rates were likely to keep compressing in 2022 despite rising interest rates.  And JLL recently saw similar mechanisms at work, opining that cap rates will continue to stay low and noting that factors like net operating income (improving with higher rents) and pure premium risk can act as offsetting pressures, pushing cap rates low.