Can someone ELI5 why anyone would buy something a 5.00% cap rate if the 10 year treasury is at ~4%? Seems like a ton of additional risk relative to the spread. I understand cap rates/bonds are not directly correlated, but at some point something has gotta give if I can get a 4% returns with 0 risk.... Is there a spread between cap rates/10 year you guys have in mind that when analyzing a deal to be palatable for investors given the state of the market?
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This is by no means a complete list, but here are a few possible items to consider:
A) 1031 exchange / other tax advantages
B) Anticipated appreciation over the holding period or repositioning of an asset
C) Diversification of your portfolio
D) Depends on the asset class but it could be a potential hedge against persistent inflation
A. Remember you are not just buying real estate for the cash flows, you also have asset appreciation. Hope is you buy something at $100 today, you get $5 of NOI today then $5.25 in Y2, and so on. Then in 5-7 years, you bought at $100 but sell it at $110. And sometimes in markets like NY/SF/BOS/DC, your asset benefits from cap rate compression - which juices returns even further. Bonds have fixed payments throughout the life cycle and upon maturity, you just get your initial capital back.
B. Real estate is a hard asset, for which you can theoretically own in perpetuity + pass down generations. A lot of folks rather invest in real estate because it’s much more understandable to common people than trying to navigate the often complex bond market.
Going to say a big flaw to this theory is that you assume someone buys a bond at issuance and holds it until it matures. You can trade bonds above and below par through their lifecycle, and achieve returns greater than just coupon payments
Could be a value-add deal with a solid refi in a few years. Some, like Dr. Linnemman do not believe there is that much of a correlation between treasuries and cap rates.
Personally, I believe there must be some causation with other more prevalent factors (IE, liquidity and risk)
In addition to the other great responses below, leverage. Your average investor doesn't have access to the kind of 90-95% leverage that some big shops have when they buy treasuries and thereby juice yields. Every real estate investor has access to mortgage debt.
Also, characterizing treasury notes as "zero risk" is kind of a misnomer. They have low risk, which isn't the same thing. Go buy a Section 8 building - the rent roll is guaranteed by HUD, which implies an equal creditworthiness as a US Government bond.
Ozy, this may be a very dumb point, but what is the point of leverage if your debt cost of capital is 100 bps above your unlevered yield (5 cap vs 4% UST + 200 bps spread)?
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