Looking for thoughts from folks on cap rate spreads over the 10 year.
My thinking is as follows: as treasury yields rise, cost of capital (debt) rises and risk free bonds become relatively more attractive, thus resulting in RE investors requiring higher returns, resulting in lower prices and higher cap rates.
Of course I know things aren’t always this straightforward. For example, now that rates aren’t expected to go up this year, you’d think that is good for cap rates/RE values. However, the underlying reason for continued low rates is slowing economic growth. Given this, I’d expect cap rates to rise somewhat given growth concerns.
Any thoughts on my reasoning here? Feel free to start a discussion!
Cap rates will never go back up. All you need to do is believe.
Your cap rate is the equity return of the asset investment on an unlevered basis, so mathematically as treasury yields rise the equity return/cap rate has to rise since the risk free rate has risen. Generally one can think of the rate of change of the cap rate/slope as its duration similar to a bond, unadjusted for maturity since equity tends to be held in perpetuity. That said, the higher the coupon rate the lower the sensitivity, so in similar fashion a RE asset with higher NOI will be less sensitive than a lower NOI re asset to interest rate changes. This ignores confluence of other factors: higher cost of debt capital yes will bring down equity yields so cap rates will trend up to account, higher debt costs will drive down buyers in a market unable to obtain financing and drive up cap rates, and supply/demand impacts of new construction due to higher leverage costs, all offset by the intrinsic value of the asset (location, type, class, etc). So the correlation is not exact here in my opinion.
Yes, the other key factor of cap rates is the rate of income growth. If you are in a market where rents, net of inflation, are rising rapidly cap rates will be lower. The flip side is cap rates could come under pressure not just from the 10 year going up but by slowing or contracting growth. Renters/tenants could also become tapped out, or new supply could result in more competition on pricing. As always it depends on the market you are in. No deal should ever be based simply on cap rates.
It should vary between 0 and 500bp.
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