Kroll Sees Modest Cap Rate Hikes if Treasury Yields Don’t Climb Too Much
June 13, 2022 | James Sprow | Blue Vault
Capitalization rates, or yields that property investors seek from their investments, generally have changed as risk-free interest rates have moved. At times, those movements have been substantial.
But as long as the yield on the 10-year Treasury note – the risk-free rate of return – doesn’t increase by more than one or two percent from where it is now, cap rates should increase only modestly, according to Kroll Bond Rating Agency. As cap rates increase, property prices decline, all other things remaining unchanged.
The rating agency made its determination after evaluating cap rates changes over the last 50 years. It analyzed cap rate data on more than 115,000 loans totaling $1.32 trillion compiled through the American Council of Life Insurers’ commercial mortgage commitment database and nearly 130,000 CMBS loans in the Trepp Inc. database. Those were in CMBS deals issued between 1996 and the first quarter of this year. It took reported property-level net cash flow and dividing that by collateral appraised values to come up with cap rates.
It found that cap rates typically have moved with interest rates. As the latter increased, so did cap rates, but often the difference between the two changed, widening during periods of illiquidity and otherwise tightening. So, the relationship between the two isn’t static.
Kroll determined that cap rate increases could be small, depending on the types of loans made. But it noted that during a period of extended rate increases, particularly if coupled with a period of stagnant economic conditions (stagflation), cap rates would increase more sharply, as they did between the 1970s and 1980s.
It found that between 1995 and 1999, cap rates remained within a 100-basis-point band between 9 percent and 10 percent, while interest rates during that period moved from 4.66 percent to 6.78 percent, a 212-bp difference.
The remained flat or declined during two other periods since 1996, when interest rates had climbed over a span of at least two years.
Similarly, between 2016 and 2021, cap rates remained between 5 percent and 5.6 percent, while interest rates moved from 0.65 percent to 3.04 percent.
The widest spread between cap rates and interest rates took place between 2012 and 2013, when it was 476 bps, and between 2016 and 2017, when it was 452 bps. During the first quarter this year, the spread had narrowed to only 334 bps. It had been tighter on a number of occasions, between 2018 and 2019, when it was 284 bps. And in 2007, as property values were being inflated by cheap and plentiful debt capital, it was a mere 151 bps. In 2000, the spread was 234 bps.
The overall average spread between interest rates and cap rates was 334 bps, Kroll found.
The general decline in caps rates since 2019, when it was roughly 6 percent to now, has been attributed to relatively healthy economic conditions. Those conditions are led primarily by low unemployment and continued strong consumer spending, and the expectation for continued rent increases at multi-family and industrial properties.
Cap rates for multifamily and industrial properties reached their post-GFC lows during the first quarter, at 4.57 percent and 4.82 percent, respectively. For multifamily, the cap rate equates to a 262-bp premium to the 10-year Treasury yield, and for industrial, a 287-bp premium. In contrast, the cap rate for hotel properties during the period was 7.89 percent, for a 594-bp premium, and for retail, it was 5.77 percent, for a 382-bp spread. The office cap rate was 6 percent, for a 404-bp premium over Treasury.
Kroll found that cap rates tightened soon after the pandemic was declared in March 2020. It attributed that to lenders avoiding certain property types, such as hotels, which typically carry higher cap rates. Removing hotel loans from the mix helped lower the overall cap-rate picture.
Credit spreads are likely to widen as the war in Ukraine and China’s penchant for economic lockdowns as a strategy to combat the coronavirus pandemic continue. That, Kroll indicated, could put pressure on cap rates to increase, which would translate to lower property pricing, but it noted that as long as the 10-year Treasury doesn’t increase too much, the spread between interest rates and cap rates could tighten.
Source: https://crenews.com/
