Is the relationship between cap rates and interest rates broken?

[Neal Bawa]

Savvy apartment Real Estate Investors know that the most common benchmark for measuring returns and gauging pricing for commercial real estate is the cap rate. The cap rate is the annual return that investors receive on their investment before the use of Leverage, i.e debt. if you look back in the numbers for the last five or six decades, there is no doubt that cap rates go up when interest rates go up. However, there are a large number of myths involved, when considering the connection between cap rates and interest rates. Firstly, people believe that if interest rates go up by 1 Point, let's say from 5% to 6%, then cap rates must go up by 1%. As far as I know, this has never happened. While it has been reasonable to assume, at least in the past, that rising interest rates would lead to an increased cap rate, it is never a one-to-one ratio. Back in the 80s, when interest rates were as high as 18 to 21%, cap rates were still single digits. This despite the fact that financing for multifamily properties was harder to get in the 80s then it is today. Cap rates did rise back in the 80s when interest rates rose, they just did not rise in a one-to-one ratio. Today, it's more reasonable to assume that if interest rates go up by 1%, cap rates might go up by 0.1% to 0.2%. That's a better rule of thumb. Having said that, let's look at what's really happened in the past 4 years. The Federal Reserve started to threaten that they would raise interest rates in the 2014 time frame. They finally did start raising rates and at this point have raised them about a half a dozen times. And have provided clear indications of at least four further increases in 2019 and 2020. And what has happened to cap rates in areas such as multifamily? There has been absolutely no evidence that cap rates have increased whatsoever during that time frame. There is very strong evidence that cap rates have continued to decline over the last two-and-a-half years, while the Federal Reserve raised interest rates. This has happened in the class A, the class B and The Class C markets. It has happened across the board in all of the top 50 metros in the United States. While there are isolated examples of certain metros such as New York seeing increases in cap rates, it is also very clear that those increases were tied to large amounts of incoming Supply, not tied to increases in interest rates. So, looking at the evidence, it is clear that cap rates are not obeying the rules of interest rates, or the rules of money, at least so far in this cycle. for the rest of this post, I'm going to speculate on why this has happened. I start off by saying that this is speculation. However it is backed by a number of monetary policy articles from both real estate professionals as well as Finance professionals. Here is why I think that the relationship between interest rates and cap rates has been broken, and may remain broken for at least a decade. To recover from the 2008 recession, the United States Federal Reserve launched an extensive program called quantitative easing. Under this program, the Federal Reserve increased liquidity in the market by over 4.3 trillion dollars. Other central banks in the world followed suit, and the European Central Bank, Japanese Central Bank and the Chinese Central Bank also printed trillions of dollars and injected liquidity into the financial Marketplace. This liquidity, which was introduced through the central banks buying bonds and mortgages, was supposed to be temporary. Unfortunately, it has been anything but temporary. At this point, ten Years After the 2008 crisis, only the United States Federal Reserve has withdrawn any of this liquidity from the market. Of our 4.3 trillion dollars, we have withdrawn a puny 300 billion dollars. At the current rate it would take us over 10 years to withdraw all of our liquidity. And keep in mind, this is only a fraction of the worldwide liquidity injection. The European Central Bank and the Japanese Central Bank have not even given any indication as to whether they will withdraw this liquidity at any point in the future. So why does this liquidity matter? and why is it part of a discussion about the relationship between cap rates and interest rates? Well, because these trillions of dollars are looking for yield. Money, once created as debt, races around the globe looking for yield, looking for profit. As central banks cut interest rates around the world, the inflation-adjusted yield for money turned negative. In fact, in countries such as Switzerland, if you buy a 10-year Government Bond, you do not get interest on it. Shockingly, you pay the government for the privilege of lending the money. While our Federal Reserve has raised rates somewhat, no one else in the world has bothered to do it. So we have this unprecedented situation of having over 13 trillion dollars worth of bonds worldwide that are at zero yield, or negative yield if you adjust for inflation. This money is desperately looking for yield. Pension funds worldwide that hold such bonds are at risk of bankruptcy. They are changing, morphing, even breaking their own rules to invest this money into risk assets such as real estate. This Is Why Real Estate assets around the world have gone up. Many people in the United States think that multifamily real estate is in a bubble. Have you looked at Singapore, Hong Kong, Canada or London real estate? Those pricing increases make our market look positively subdued. This despite the fact that of all of the economies just mentioned, the United States is easily the most functional, the most liquid and has the strongest foundation of growth. After all, only our Federal Reserve has been brave enough to raise interest rates, no one else has. That is because we have the strongest economy in the developed world today. this is why money from those zero yield bonds has been flowing into the United States, and flowing into commercial real estate. As these trillions of dollars flow in, they are warping, even destroying the relationship between cap rates and interest rates. This is why we have seen 6-7 interest rates hikes, with declining cap rates. This is because that money can still get double-digit yields in the United States, where it gets zero yield if invested in bonds. Why would money managers for large funds care that cap rates are declining while interest rates are increasing, if they can make 10% on their money? This doesn't mean that cap rates can continue to go down infinitely. In fact if you look at the latest reports, it appears that cap rates have plateaued for the moment. However, as the demand for apartments goes up and new construction gets hit Harder by the higher interest rates, it is likely that cap rates could resume their downward trend. until the world figures out how to get the trillion-dollar liquidity genie back in the bottle, the rules of money may remain perverted. What do you think? Does this explain why cap rates continue to decline, when they shouldn't be?