Was talking to some buddies last night going over our interviewing process when applying to jobs. There was one question that virtually all were asked: "What is the relationship between cap rates and interest rates?"
I'm sure you all have had this question in an interview at some point. Is there a true answer/relationship between the two? We thought it was a pretty bogus question to ask a college junior/senior because I know there have been times when the two have not moved in sync.
FWIT - I said that a rise in interest rates leads to higher pricing, which would decrease the cap rate.
Is this for Ibanking SA?
Wouldn't a rise in interest rates lead to lower pricing and an increase in cap rates? For 2 reasons:
1) If interest rates are higher then investors can get better returns on treasuries, etc and therefore the cap rates of real estate would increase (pricing = decrease) in order to match the increase in returns that can be received elsewhere in the market. Put another way, if better yields/returns can be received elsewhere then demand for real estate would drop until the price decreases enough to compete with those competing yields/returns.
2) Higher interest rates make the debt on the real estate more expensive which means you have to pay a lower price to hit your returns
I would disagree. Cap rates and interest rates are generally positively correlated, although not always. Since the recession, we saw interest rates fall sharply and cap rates have moved in a similar manner. Now that interest rates are rising, borrowing becomes more expensive making levered investments (like real estate) less attractive. This is everyone's fear that cap rates will rise, hurting the possibly inflated property values.
That was my thinking too. I feel that the question was worded poorly, as the interviewer seemed to be asking for the exact relationship between the two. Then again this was two years ago, can't remember exactly how he put it.
Rising rates would increase cap rates as investors can no longer pay the same price for the same leveraged cash flows that they could receive pre-rate rise. You would need to pay less up front. However, Global Capital Markets and Cross Border flows have created a scenario where foreign capital has nothing stopping it from flowing into US ("safe") real assets--bond yields would theoretically need to rise with interest rates, but if the spread spread between corporates and real estate cap rates is significant to begin with, investors may still opt for buying a building vs. a corporate bond for the yield. I think there is a loose correlation but not 1:1 by any means.
An excerpt from a TIAA study is one way that I think about it (this is talking about cap rates for Core assets in the US relative to the 10-year): "The cap rate spread as of March 31, 2016 is 436 basis points, or 113 basis points higher than the long-term historical average of 323 basis points. The extra spread can absorb a small increase in 10-year Treasury yields and/or a further reduction in cap rates before property values are affected. The spread margin can be viewed as a protective buffer from the expected rise in interest rates." I know that doesn't necessarily answer how they move relative to each other, but I hope it's helpful nonetheless.
You should have answered:
"I build many buildings, many big, beautiful buildings - the best. I have so many buildings, I have them all over the place. I just sold a building for $150 million to somebody from China. Am I supposed to dislike them?... I love China. The biggest bank in the world is from China. You know where their United States headquarters is located? In this building. I don’t need anybody’s cap rates. It’s nice. I don’t need anybody’s cap rates. I’m using my own cap rates. I’m not using the lobbyists. I’m not using donors. I don’t care. Our interest rates will be THE BEST interest rates in the world."
This has my day off to a wonderful start...
So yes at the others above mentioned, theoretically rise in interest rates would be investors demand higher cap rates. However, here is why this does not always work. The world is more connected than ever. A rise in US interest rates may not mean a rise in cap rates, if China keeps their rates suppressed. In a situation like this, you'll see foreign investors still keeping cap rates low because their domestic interest rate is still low. It's all relative. We are seeing this exact impact from Chinese investment groups in Manhattan.
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