Interest rates and cap rates: A tale of two scenarios
Jan 31, 2017, 14:47 PM
With the Federal Reserve expected to increase policy rates in 2017, CRE investors are asking whether and how it will affect U.S. cap rates. According to our research, the answer is (in typical economist fashion), "it depends." It depends on whether rising interest rates occur concurrently with—and as a result of—higher economic growth. If the U.S. economy were to exhibit strong growth over the next two years (stemming from, say, tax and regulatory reform and infrastructure spending), our research indicates that cap rates would not increase by much—even with a 100-bps increase in 10-year U.S. Treasury yields (which would leave cap rates significantly compressed). Such a scenario is indicated by the dashed-line forecast in the chart below.
Alternatively, if economic growth next year were lackluster, then the Fed’s increase in policy rates—the short end of the yield curve—would not have an appreciable effect on longer-term rates. Cap rates would remain relatively flat, but their spreads over Treasurys would be quite wide. (See the solid-line forecasts in the chart below.) The bottom line will be what happens to U.S. economic growth in the next two years, as this will be more important than U.S. monetary policy in determining the behavior of cap rates. Economic growth is the key metric to watch.
NCREIF NPI Cap Rates, National Sectors: Baseline vs. Higher Interest Rates & Growth (Dashed)