Interest Rate and Cap Trends--Fall 2013

Last Friday, the Federal Open Market Committee (FOMC) announced their decision to leave the monthly $85B bond buying program unchanged for now.  This action is countered with the consensus that the Fed will begin tapering its bond buying program within the next year, thus lowering demand for bonds and increasing the interest rate.  The Fed realizes there are significant struggles in the economy and different signals that are opposed to each other.  While unemployment is down, the labor force participation rate is the lowest it has been in decades and new job growth has largely been part-time in nature.  While inflation seems to be in check with the Fed’s measurements, anyone who has gone to a store recently can tell you otherwise.  While housing seems to be recovering, the impact of higher mortgage rates and underwriting standards tend to mute those gains. 

The decision to continue the Quantitative Easing caused a steep drop in 10 year rates, which have raised over 100 basis points this year.  This should benefit the residential sector.  If underwriting standards ease, this expanded access to credit is a prerequisite for a sustainable economic expansion.  A continued accommodative lending environment will aid in the refinance and restructuring of maturing loans and more capital will favor real estate as a sound alternative to low-yield bonds and volatile equities. 

But even with the sharp increase in rates this year, Treasuries remain close to their 50 year low and are at less than half of their long term average.  Cap rates on real estate, defined as the net operating income divided by the price, have declined to an average of 7.2% on all commercial real estate.  The gap between the 10-Year Treasury and commercial cap rates has fallen from 490 bps down to its present level of 440 basis points.  This is still 60 bps above the long term average.

A wide range of factors have come together to change the structure of commercial real estate values.  The intertwining of the US and world economies, deep integration of debt and equity markets, and the addition of financing vehicles such as REITs and CMBS have all contributed to the change.  Data transparency, deeper liquidity and broader investment strategies have also helped better measure investment risk.  All these factors have pushed overall cap values down for the past 20 years. 

Cap rates tend to remain within a certain range during economic peaks and valleys, with typical variances of 100 to 130 basis points.  Cap rates behaved quite similar in the last two recessions, though the duration and severity of the economic downturns were different.  Current cap rate trends have also differed between major metropolitan markets and other markets. So far for this year, apartment cap rates are down 20 bps in the major markets and 40 bps in the secondary markets; retail is down 10 bps in the primary markets and 40 bps in the secondary; office is down 30 bps in the primary and 40 in the secondary; and industrial is down 40 bps in the primary markets and 80 in the secondary.  Here in the Dakotas, we would be classified as a secondary market.  We can also attest to possibly more cap rate decreases in this area due to the strong economic growth prevalent in our area.

If you believe the consensus of the experts, we can expect interest rates to stay low in the short term and begin to rise as the Fed slows down its bond buying.  Cap rates should continue to decline slightly which will continue to increase commercial real estate values.