Transcription
There are a lot of different factors that play in real estate cap rates. But with the changes in interest rates we've seen over the last 2 years, and especially over the last few months, there are a lot of expectations from investors right now around how these most recent changes are going to affect cap rates in the market.
But even after a 50 basis point rate cut back in September, and even more rate cuts projected throughout the rest of 2024, this might not end up having the impact on cap rates that investors have been hoping for for a few different reasons. So, in this video, I want to talk through two of the the biggest drivers of cap rates in the commercial real estate market, how and why interest rates end up playing into these, and why commercial real estate values might still take a while to recover, even if the Fed funds rate continues to drop.
So, just as a quick refresher, cap rates can be calculated by taking a property's annual net operating income, or NOI, and dividing that by the property's value, which essentially tells an investor what their going-in unlevered yield will be on an investment before factoring in things like loan proceeds, loan payments, or major capital expenses. And this means that at the same NOI levels, when cap rates expand or rise, property values decrease, and when cap rates compress or fall, property values increase. And this makes cap rates a really big focus point when it comes to the health of the real estate market.
And while there are a lot of different factors that can influence these, two of the biggest things that tend to shape cap rates in commercial real estate are interest rates and changes to these over time, along with demand for commercial real estate, specifically from the capital markets.
So, to start with the interest rate side of the equation, as a general rule of thumb, as interest rates fall, cap rates also tend to fall, and as interest rates rise, cap rates also tend to rise, primarily due to higher interest costs having a material impact on investor returns, all else being equal.
And to use an example to illustrate this, let's say an investment firm is looking at a property with a $6 million going-in NOI, and they'd also be financing this acquisition with a 65% LTV loan at a 5.5% interest rate, amortizing over 30 years. Let's also say that NOI growth is expected to be 3% per year, and the property is assumed to be sold at a 6% cap rate after a 10-year period. Now, based on all of this information, if this investment firm had an IRR target for this deal of 14%, they could reasonably offer $9.8 million for the property and still hit their target return. However, if everything stayed the same on this deal, but the interest rate dropped from 5.5% down to just 4%, this investor could now raise their offer price up to $10.4 million and still hit their IRR target, which represents more than a 6% value increase over that original scenario.
And since many commercial real estate investment firms, especially major institutions that deploy billions of dollars of capital into the real estate market, tend to advertise these return targets when raising capital from investors, movements in interest rates can cause huge and widespread changes in property pricing throughout the entire industry.
Now, the hope of many real estate investors right now is that if the Fed continues to decrease the federal funds rate, these types of value increases would end up materializing. However, just because the federal funds rate falls doesn't necessarily mean that all interest rates are going to fall in lockstep. And while some rates are dropping right now, others are dropping a lot less, or even projected to increase over the next few years.
When the federal funds rate drops, this typically also results in the Secured Overnight Financing Rate, or SOFR, dropping. And this tends to be the index rate used by lenders to price floating-rate commercial real estate loans within the US. And since the first rate cut on September 18th, we've seen this rate come down pretty significantly, which has been a benefit for borrowers that currently have floating-rate loans, and also borrowers that are considering using floating-rate debt on new acquisitions or development projects.
But for investors looking for fixed-rate loans today, this is a very different story. Since that first interest rate cut was announced back in September, the 10-year US Treasury, which tends to be the index rate used by lenders on 10-year fixed-rate loans, has risen from about 3.7% at that time all the way up to above 4% as of the middle of October. And even though loan spreads have come in a little bit as lenders have started to gain more certainty around the intentions of the Fed going forward, fixed interest rates today are even more expensive than they were before that 50 basis point cut was announced.
And on top of that, we're also seeing forward interest rate projections for the 5-year, 7-year, and 10-year US Treasury rates, which are used to price 5-year, 7-year, and 10-year fixed-rate loans, to actually increase over the next 10 years, even as SOFR is projected to continue to fall. This means that even if the Fed continues to cut rates, this won't necessarily cause an immediate spike in real estate values, and treasury rates will very likely need to go in a very different direction before that starts happening.
Now, on the investor demand side of the equation, this really comes down to the amount of active capital allocators that are interested in investing in commercial real estate, which is heavily influenced by how they perceive risk within this particular asset class. When investor demand falls, cap rates typically rise, since there's less price competition from buyers in the market. And when investor demand spikes, like we saw in late 2021 when capital poured into commercial real estate, cap rates can end up falling at a really rapid pace.
And with so much media coverage over the last few years highlighting distress in the office sector and parts of the multifamily sector, this has caused a huge uptick in the perceived level of risk associated with investing in commercial real estate today, which has also put upward pressure on cap rates during this time. CBRE released a report earlier this month which shows this pattern really clearly, with material cap rate increases after the dot-com crash, after the Great Financial Crisis, and after the most recent Fed tightening cycles starting in 2022. And during these times, investors tend to move away from real estate and into other asset classes that are more desirable at the time.
Investor demand can also be heavily influenced by other factors, including inflation expectations, GDP forecasts, and even the performance of other investment vehicles in the market. And with the S&P 500 up over 52% since January of 2023, public equities have become a significantly more attractive option than commercial real estate has been over the last few years. And with consumer confidence at a significantly lower level than it was back in 2017, and recession fears still looming for many investment firms right now, this might not change anytime soon, and it could take a while for commercial real estate cap rates, and ultimately values, to come back and recover if things continue as is.
Ultimately, the big takeaway here is that cap rates are most heavily impacted by changes in the specific interest rates that are directly tied to pricing commercial real estate loans, along with changes to investor demand for real estate overall. And as interest rates rise and demand falls, cap rates tend to increase, and as interest rates fall and demand rises, cap rates tend to decrease.
And if you want to learn more about how cap rates play into commercial real estate investment analysis, or you need to prepare for an Excel modeling exam that might be given to you when interviewing for roles at commercial real estate investment, development, or brokerage firms, make sure to check out our all-in-one membership training platform, Breaking Into CRE Academy. A membership to the academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis. You'll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you'll also get access to the Breaking Into CRE Analyst Certification exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.
And if you like this video and want to see more content on the channel on commercial real market analysis, make sure to hit the like button, let me know, and let me know in the comments where you think cap rates are going to go throughout the rest of 2024 and into 2025. As always, thanks so much for watching guys. I hope you found this helpful. Subscribe to the channel if you haven't already to see more videos like this every single week, and I'll see you in the next video.