The Importance of Cap Rate Spread in Commercial Real Estate
Cap rate spread is defined as the difference between the cap rate of commercial properties and current interest rates, typically measured by the 10-year Treasury Rate. Cap rate spread is an important indicator of risk, as U.S. Treasury bonds are considered virtually “risk-free,” while real estate investing involves a considerable degree of perceived risk.
The difference between a real estate investment’s return and the accompanying U.S. Treasury return is referred to as the “risk premium,” or the additional reward an investor gets for taking risk in the market.
Cap rates generally rise along with interest rates. However, the difference or “spread” between cap rates and Treasury rates is generally higher in times of economic turmoil, and lower in times of economic growth and stability. As cap rate spread increases, investing in real estate becomes more rewarding, but also riskier than investing in Treasury Bonds.
In this article, we’ll discuss the importance of cap rate spread for real estate investors, examine how it impacts investor behavior, and look at how and why cap rate spread changes over time.
Cap Rates Defined and Explained
Before fully discussing cap rate spreads, it’s important to define cap rate itself.
Cap rate, or capitalization rate, is one of the most important metrics for commercial real estate investors. Cap rate is calculated by taking a property's current market value and dividing it by the property’s NOI (net operating income).
The formula for cap rate is:
Cap Rate = Net Operating Income / Property Market Value
Net operating income (NOI) is determined by taking a property’s gross rental income and any ancillary income and subtracting operating expenses, taxes, and other ancillary expenses, such as replacement reserves. For example, a $1 million property with $100,000 in NOI would have a cap rate of 10%.
It’s extremely important to realize that cap rate does not incorporate debt. The vast majority of commercial real estate projects are financed with loans, and, while loans increase risk, they can greatly increase a commercial property’s return on investment (ROI), as calculated by metrics such as leveraged IRR (internal rate of return) or cash-on-cash return. Depending on the amount of leverage and interest rate, the $1 million mentioned above could have an IRR or cash-on-cash return of 15% or more.
Why Cap Rates and Interest Rates are Correlated
Cap rates and interest rates are correlated due to the fact that both Treasury bonds and real estate compete for investor capital. Lower Treasury rates mean that investors will turn to higher-interest investment vehicles, including stocks, bonds, and real estate, in order to generate a higher return.
Treasury rates are controlled by the Federal Reserve, and generally, low interest rates are heavily linked to quantitative easing and other methods in which the Fed indirectly injects money into the economy. Lower interest rates reduce the cost of capital, make it relatively less expensive to finance commercial real estate, which increases demand for properties.
Higher demand for real estate means also higher property prices, and with a constant NOI (net operating income) the same property will have a lower cap rate. For example, if the value of a property with an annual NOI of $100,000 increases from $1 million to $1.2 million in a hot market, the cap rate will decline from 10% to 8.33%.
Cap Rate Spreads and Real Estate Investor Behavior
Inexperienced real estate investors often believe that current trends will continue well into the future. Therefore, when rents fall and vacancy rates increase, real estate investors perceive investing as riskier, which leads to increased cap rate spreads. When rents rise and markets are strong, cap rate spreads decrease due to the decrease in perceived real estate investment risk. In fact, multiple studies show that the period of the real estate cycle in which rents reach their peaks is exactly the same period in which cap rates are the lowest.
In contrast, more experienced investors typically understand the concept of the cap rate cycle, and, instead of purchasing properties when cap rates are low, they purchase when cap rates are high, paying relatively less for the same stream of income.
Savvy investors generally research historical cap rates and compare them to current cap rates to determine which part of the market cycle they are currently in. Historical cap rate information is published by major real estate services firms like CBRE, while more detailed information can be purchased for a fee from NCREIF. Another good source of historical cap rate data is Real Capital Analytics, particularly for transactions occurring in major MSAs (metropolitan statistical areas), like New York City or Los Angeles.
For example, during the height of the last financial crisis (2007-2010), cap rates rose while 10-year Treasury rates declined, resulting in increased cap rate spreads. Cap rates and cap rate spreads vary based on property type due to perceived risks. Riskier property types, like hotels and office buildings, generally have both higher cap rates and higher cap rate spreads, while more stable assets, like multifamily and industrial properties, typically have both lower cap rates and lower cap rate spreads.
The cap rate cycle can be seen as one component of the larger real estate cycle, in which the fluctuations in property values and rents are tied to the larger economic cycle of supply and demand. The real estate cycle, however, is far more sluggish than the general economic and stock market cycle due to fact that real estate transactions and leases are measured in the months, not minutes. In fact, data suggests that it takes six months for a stock market crash to fully impact the price of real estate.
The short-term supply of real estate is fixed, so when demand decreases due to economic shocks, occupancy rates decrease quickly, leading to a decline in rents and prices. However, this can take several months to occur. When those rents decline, demand will typically increase, and with it, occupancy rates will increase as well.
Cap Rate and Cap Rate Spread Factors for Individual Properties
While we’ve mentioned that interest rates and cap rates are strongly correlated, interest rates are only one factor that impacts cap rate spread increases or decreases. As with all types of economic indicators, supply and demand are the main drivers of cap rate changes. For individual properties, supply and demand are typically affected by factors including:
Leasing Activity: For non-multifamily commercial properties, long-term leases, particularly triple net (NNN) leases, to high-quality tenants generally result in higher valuations and lower cap rates due to less perceived risk. In contrast, shorter leases to lower-quality tenants increase perceived risk and increase cap rates.
Market Factors: In good economic conditions, prices rise due to strong demand, decreasing cap rates. The opposite can be said in bad economic conditions. Typical market factors include population growth or decline, employment levels, wage levels, and new job creation rates.
Local Market Factors: In neighborhoods that improve, or “gentrify,” prices and cap rates will generally decrease, while in neighborhoods that decline, City development plans, new laws, and hyperlocal economic factors, such as the opening or closing of a local business or businesses can impact local markets, property values, and cap rates.
Property Improvements: Property improvements can immediately increase a property’s value, however, they may not immediately lead to an increase in rents. When a property’s value increases and the NOI stays the same, it will lead to an increased cap rate. However, if property value and rents increase simultaneously, the cap rate will remain the same.
Cap Rate Compression vs. Cap Rate Increases
A decline in market cap rates is often referred to as cap rate compression. This occurs when property value rises in comparison to NOI, and may or may not be correlated to a decrease in cap rate spread. Cap rate compression is great for real estate investors currently holding onto properties but is not so ideal for investors looking to make acquisitions, as it means that they will be paying relatively more for the same amount of rental income.
Cap rate compression occurs due to many of the factors mentioned above, including positive general and local market factors, interest rate decreases, and leasing activity, all of which directly impact supply and demand.
In Conclusion: Understanding Cap Rate Spreads and the Cap Rate Cycle is Essential
As we mentioned in the beginning of this article, cap rates and interest rates are highly correlated. Cap rate spreads increase in times of economic volatility and decrease in times of economic stability. Cap rates are constantly changing, and vary based on a variety of market and individual property factors, as well as by asset type.
Smart investors generally purchase properties when cap rates are higher, and see cap rates fall as their properties appreciate over time. Therefore, understanding how cap rates correlate to interest rates, and, more broadly, the real estate and cap rate cycles, is important for commercial real estate investors who want to make smart decisions to reduce risk and maximize potential profits.