With Interest Rates Expected to Rise, Will Cap Rates Follow?

Since the beginning of 2018, interest rates have meaningfully risen, with the 10-year Treasury increasing from 2.48% on January first to 3.00% in early May.  The Fed continues to indicate it will keep raising rates, which will likely push up short term rates, even with 30-day LIBOR having already risen by approximately 100 basis points in the past year.  This rising interest rate environment has fueled many in the real estate industry to speculate that cap rates will also rise in the coming months because rising interest rates directly reduce the cash flow of levered properties.

We believe, however, that cap rates are more likely to stay flat or perhaps only slight rise in the coming year, for several reasons.  First, we view real estate as an attractive investment alternative relative to other asset classes at this time.  Fixed income yields are still low and will experience lost value as interest rates rise.  Equity markets appear to be stretched as far as they can go from a valuation perspective.  For investors seeking higher income yields and moderate total returns, real estate will continue to look attractive to many, so capital should continue to flow to the sector.  Secondly, reportedly there is an abundance of capital sitting on the sidelines in the real estate market. According to PwC and Preqin, this amounts to more than $250 billion of undeployed capital (“dry powder”) sitting in real estate funds and waiting to be invested.  The sheer volume of capital seeking deals in the space are likely to keep a lid on any rise in cap rates.  As noted by the CEO of a public company at the Urban Land Institute Spring Conference in early May, dry powder held by real estate funds has doubled since 2007 yet the number of transactions are down 18% in the same period of time.  More capital chasing fewer deals means prices are likely to stay high.  Lastly, reported spreads on real estate loans over treasury rates have come down over the past few months as interest rates have risen, leading to less impact on borrowing costs than the headlines may suggest.  Our conclusion is that low cap rates are likely here to stay for at least the coming year. 

 

Casey Wendeln

Senior Vice President, Portfolio Management 

 

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.