The 10Y Treasury Note (T-note) is used as a proxy for mortgage rates and is believed to be a bellwether for investor sentiment. For this reason, many investors believe that when the 10Y Treasury yield rises, cap rates will follow suit.
“Contrary to conventional wisdom,” a Berkadia whitepaper notes, “bond yields and cap rates do not have a one-to-one relationship.” Instead, the correlation between the two varies over time. Their relationships can be further distorted by deflation/inflation or disinflation, as at times bond yields and cap rates may move together, separately, or be “largely uncorrelated.”
A second Berkadia whitepaper takes a closer look at the interplay between actual inflation, inflation expectation, yields on the 10Y Treasury, and cap rate yields. They find that both changes in actual and expected inflation are related to 10Y Treasury yields, but that expected inflation proves to be a stronger corollary.
Further, they find “nominal cap rates behave a lot like real interest rates.” Plotting the average spreads between cap rates and the 10Y Treasury alongside those of real Baa corporate bond yields (DBAA) and the 10Y Treasury, they find “the average cap rate spread is equivalent to the average real DBAA spread plus a roughly constant delta.”
Though cap rates and T-note yields do not have a one-to-one relationship, they note: “Post-GFC, a 100-bps movement in nominal (T-note) yields and inflation-adjusted (T-note) yields is associated with a movement in the average cap rate of 51 bps and 44 bps, respectively.”
Significantly, though, they add that cap rates can remain “sticky” as cap rates from the immediately prior quarter will be most highly correlated with cap rates from the current quarter.
Each whitepaper was focused primarily on multifamily data.
Taking a broader range of CRE asset types, a whitepaper presented by Crow Holdings and SMU Folsom Institute for Real Estate attempted to project (in Q2 2022) how cap rates would respond to the rise in the federal funds rate over the course of the year (given an expected rate hike trajectory that did not end up matching the actual rate hikes made in 2022). It takes a historical view of the topic, focusing first on the real estate cap rate spread in relation to the 10Y Treasury yield. Second, it analyzes this spread in light of a varying inflation rate, and finally it notes the relationship between the yield on the 10Y note and short-term interest rates. Together, it frames a conversation around cap rates, based in the historical trend. Though its predictions about the Fed’s moves have not proven correct, the analysis is worth a read (if you’re feeling nerdy, that is).
So where does this leave CRE? Market participants will be keeping a close eye on the federal funds rate in March and May, and any accompanying commentary the Fed will provide at those points. The question will remain, too, how long will the elevated interest rates remain after the Fed enters a holding pattern? (The Crow Holdings whitepaper notes that for the most part the Fed has reduced rates by 200 bps within 12 months after the peak in their rate hike cycle.)
Now—as always—the valuation professionals at Valbridge remain committed to keeping abreast of both macroeconomic trends and the impacts in their local markets, analyzing metrics for each subject property in light of recent comparable data.