Interest Rates vs Cap Rates


Nov 8, 2022

As I write this, a 1-year T-Bill is at 4.55%, the 10-year is at 4.10%; and a 5-year Treasury Note, a common mortgage loan index, stands at 4.25%. How is that good for commercial real estate? Let’s explore:

A quick glance at two random properties recently posted on LoopNet in my region include a mixed-use property and a STNL medical building – offering cap rates of 4.4% and 3.8% respectively. One promises upside through leasing vacant units and the other offers a long-term guarantee with a couple of modest rent bumps.

Among the myriad considerations (to be discussed in future installments), there are two obvious and interrelated issues at work here:

Firstly, be it a large fund manager or a private individual, when an investor is deciding where to allocate capital, is the industry incentivizing them toward real estate or pushing them elsewhere? On one hand there is a hassle-free return backed by the Full Faith and Credit of the United States Government, on the other hand is the risk, costs, effort and illiquidity of real estate for a comparable or even lower return. Hello? Anybody home, think, McFly, think!

Secondly is the cost of the funds that many investors need to borrow to acquire real estate (or those who responsibly use debt as a tool to leverage up yields), which, at a few hundred bps spread, can now cost upwards of 7% and heading north. That’s ~7% dollars to buy ~4% dollars.  How’s that loan working for you? It isn’t. Increasing rental used to be an argument for income properties, now you depend on it just to tread water? Hmm. Back to “Firstly”

So, maybe I’m missing something, but my Venn Diagram says that when the I-need-debt investors are removed from the large circle of all investors, all that is left is that smaller circle of all-cash investors.  And if the Invisible Hand does its invisible thing, fewer buyers mean lower prices; ipso facto (yes, I just wrote “ipso facto”), higher cap rates.

This is good. Balance is always good. The world could use a lot more of it. Supply and demand will replace artificially low interest rates in driving the market, as it should. Sellers will soon have to pull their heads out of their assets and respond accordingly or wait until such time as – were it to be in this lifetime – interest rates revert to the “norm.” Or is it more likely rates are now actually finding their norm?

Next time: the Great Reset (the not as good part)