Can anyone help explain the intuitiveness between the spread cap rate and bond yield represent? I know the spread itself represents a risk premium.
But saying spreads between cap rate and bond yields have shrunk historically for commercial assets - does this imply, a lower risk return profile? Just want to confirm or have someone explain in further detail if I got it wrong
I'll immediately disclaim that I'm no expert on this topic - from what I've come to understand through capital markets partners I work with, explaining the correlation between Bond Yields and Cap Rates is one they all claim they don't really understand the science behind - and I'm talking about firms that specialize in hedging for RE funds/REITs.
When banks raising CRE funds initially became popular, CRE yields were often compared to BBB bonds in terms of risk/return profile. So, in that context, if the spread is shrinking between the cap rates and bonds, I would incorporate that into my acquisition assessment as "is this asset worth the risk as X.XX% return if I can buy corporate BBB bonds and receive a similar return with less work?"
Would like to hear what some vets think about this
Break it down into its basic components (fake numbers).
Class A office in NYC cap rate: 4.25%
10-year bond yield: 3.00%
Spread: 1.25%
Now, spreads shrink:
Class A office in NYC cap rate: 4.00%
10-year bond yield: 3.00%
Spread: 1.00%
This isn't necessarily a commentary on risk of real estate (necessarily...). At its very core, the lower spread is a commentary about supply and demand of investment capital for said real estate. Demand for real estate could be impacted by countless reasons--tax rates/rules, regulatory environment, risk, capital appreciation expectations, etc. So the "correct" answer is that lower spread means there is greater demand for real estate relative to bonds than what used to exist, and that this lower spread could be explained by lower perceived risk.
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