Cap Rates and Interest Rates
by Petros S. Sivitanides, Ph.D.
The cap rate spread, that is the difference between cap rates and interest rates, is a very important indicator of the risk premium that real estate investors attach to property investments, which in turn influences investment strategies.
It has been empirically confirmed that there is a statistically significant positive relationship between market capitalization rates and interest rates (Sivitanidou and Sivitanides, 1999, and Sivitanides et al, 2001).1 In other words, when interest rates go up market cap rates go up too. The significant compression of capitalization rates over the period 2001-2007 has a lot to do with the historically low interest rates that have been prevailing during that period. Search Our Over 150-Page Website!
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The explanation for the strong link between capitalization rates and interest rates is that real estate competes in the capital market with alternative investment vehicles (both risky and risk-free). So, for example, when the rates for 10-year Treasuries go down investors will tend to turn to alternative investment vehicles, such as corporate bonds, stocks, and real estate. With more capital flowing to real estate, and keeping the supply of real estate investments constant, investors are forced to bid up prices. Keeping a property’s Net Operating Income (NOI) constant, higher property prices translate to lower capitalization rates. Hence, the positive relationship between the capitalization rate and the interest rate.
The interest rate, as represented for example by the 10-year Treasury rate, represents the risk-free rate of return in the capital market, as it is guaranteed by the US government. On the contrary, corporate bond rates do not reflect risk-free rates, since there is no guarantee that the companies issuing those bonds will be able to make the interest payments stipulated by the bond instruments. Within this context, the difference between the capitalization rate and the interest rate reflects in theory the risk premium investors are willing to pay to own real estate investment vehicles. Based on this rationale, the cap rate spread, or the difference between the capitalization rate and the interest rate, should increase when the risk, or at least the perception of risk of real estate investments, increases. Empirical studies have shown that besides interest rates, capitalization rates are affected by several other factors, such as factors that affect the appreciation potential and the risk profile of a property investment. See the article Capitalization Rate Influences for a more detailed discussion of the full spectrum of factors that drive movements in cap rates. Just to briefly mention them here, these factors include real estate market influences, relating to the strength and prospects of the local market, such as rent movements, vacancy rate, absorption rate, etc. and capital market influences including movements in interest rates, returns in alternative investment vehicles and overall uncertainty and volatility in financial markets. Empirical studies have also shown that real estate investor behavior is myopic. In other words real estate investors tend to extrapolate recent market trends into the future. This means that when vacancy rates are increasing and rents are falling investors tend to extrapolate such trends into the future and consider real estate investments more risky. Thus, the cap rate spread should be increasing during such periods, assuming that interest rates remain constant. On the contrary, when the market is strong, vacancy rates are falling and rents are rising, the cap rate spread should be decreasing, as investors would consider real estate investments less risky. 1Sivitanides, P., J. Southard, R. G. Torto and W. C. Wheaton. "The Determinants of Appraisal-Based Capitalization Rates". Real Estate Finance 18 (2001), 27-37. Sivitanidou, R. and P Sivitanides. “Office Capitalization Rates: Real Estate and Capital Market Influences.” Journal of Real Estate Finance and Economics 18:3 (1999) 297-3.
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