Higher Interest Rates + Late Cycle = Lower Cap Rates. Huh? For the 22+ years I’ve been in this business, investors have relied on the relationship between cap rates and interest rates. But perhaps it’s time for us to stop relying on conventional wisdom.
The general rule of thumb has been to look at cap rate as a spread over the cost of debt (typically the 10-year Treasury bill or Baa bonds). Given that we have seen a material rise in both long- and short-term base rates (Treasurys/swaps and LIBOR) and given that according to our 1H 2018 Cap Rate Survey cap rates are stable to declining across most asset classes (with tertiary retail a notable exception), investors are asking: “When is this going to start acting normally again!”
The answer is that this is normal, since cap rates are a function of growth expectations and the weighted average cost of capital (WACC), not just the cost of debt. While the cost of debt has gone up slightly, the cost of equity has dropped. The cost of debt also hasn’t gone up as much as the base rates would suggest, due to a combination of spread compression and the entrance of many new players into the marketplace. This is putting further downward pressure on cost, even for riskier loans (bridge, construction), and is shifting borrower strategies, as evidenced by an increase in the percentage of borrowers electing interest-only loans to 22% from 11% over the past year.
It is the equity side where things get more interesting. Unlike the dire predictions about the ability to roll over the so-called CMBS “wall of maturities,” which turned out to be largely unfounded, our industry has not nearly been as focused on the “wall of equity” that has been building since the tech-bubble in the early 2000s. That’s when institutional equity began to wake up to commercial real estate as more than just an alternative investment. Since then, allocations to CRE have jumped from approximately 5% of institutions’ total investment allocations to more than 10% today.