Cap Rates and Interest Rates
What is the relationship between cap rates and interest rates?
Never been able to wrap my head around it.
Would a higher interest rate vs cap rate just indicate negative leverage? What is the relationship?
cap rate simply know as expected investment yield. Too high interest (saving & lending interets) ==> too high cost of fund ==> yield tend to decrease
If your cap rate, or rate of return based on price and in place net income, is lower than your interest rate you will have negative leverage since you are paying the bank a higher percentage in interest that you are making in total unlevered yield.
They don't have a direct relationship where it would be obvious, but when interest rates rise, cap rates have to rise otherwise no deals will transact. No one would, or at least should, go into a deal with negative leverage so sellers would have no one bidding on their assets if they price it at a very low cap rate, so they lower the price and raise the cap rate. When interest rates go down, the IRR will get bigger with high cap rates so sellers will raise the prices of their assets and lower the cap rate correspondingly. Just think of it as supply and demand.
I used to be confident they were correlated as you described, but its not really true. There is some correlation of course, but its minimal and weak. Linneman put out a detailed research piece in the past year that elucidated this concept and convincingly made the case that they are not in fact correlated. Your argument above is missing the demand factor of CAPITAL in the space (i.e. allocations of major institutional behemoths to the space such as pension funds) as well as unlevered participants.
You're right. I gave an econ 101 version of the correlation because obviously there is a ton of nuance and outside factors that would create circumstances that they become less correlated. When you have people on the West coast with million dollar houses looking to 1031 after selling a house, they can just buy a STNL retail or some other smaller cap asset so the cap rates haven't needed to adjust. There are tons of deals that can be done purely on equity up to $5MM, in which case interest rates would have little to no effect. When you have institutional dry powder needing to be deployed, they will take 10% IRR on a core asset with less than ideal debt terms so they out bid the MM REPEs. The strongest correlation I have seen so far in cap rate expansion with interest rate hikes are typically in the middle market range of assets. Blackstone/KKR/Starwood are not typically going for like 100 units of MF or a 75k SF retail center and those are out of the price range of HNW investors to do on pure equity so the debt component becomes more critical and the MM REPEs either can't afford to or just don't want to clip a 7%-9% coupon with that price range.
I think there will be a breaking point where interest rates will start to show a real impact on cap rates, but it's not the 1:1 correlation that people used to think it was.
Totally with you on all of the above points. I think there is a greater degree of risk between the different asset classes as well. For example, with MF cap rates as tight as they have become, I think they have greater risk of expansion depending on how high rates how. While other classes such as hotels, I would expect to simply experience a compression in spreads rather than expansion. Will certainly be very interesting to watch how everything plays our over the next year.
As a side note, there is tighter correlation between BAA corporate bond yields and cap rates than there is with interest rates.
Baa rated bonds?
The way I always rationalize it is the cap rate is the multiple of income an investor is willing to pay to buy a property. As interest rates rise, potential investors are impacted by less leverage effect and also more attractive investments outside of real estate (i.e. Bonds) which print yield at a risk free rate. Therefore real estate "should" be less attractive as a multiple of cash flow and as a result the income multiple required to buy a property should go down.
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