What is the Long-Term Risk of Cap Rates Increasing?

How are real estate managers thinking about the risk of cap rates increasing given the shifting Federal policy and inflationary forces 5-7 years out?

15 Dec 2021 6 Minute Read Time


Americas Head of Real Assets Research

For the first time in more than a decade, U.S. policymakers are facing the prospect of inflation overshooting their stated 2% target on a sustained basis, all while benefits from record monetary and fiscal policy stimulus are set to fade. The upshot is that following a 30-year bull market run in bonds—supported in part by a surplus of global saving, lower productivity growth and slowing population growth—interest rates are likely to rise.

Markets have begun to price in higher rates and, should these expectations persist, the impact of any tightening may prove less disruptive to borrowers and lenders alike. But unlike traditional long-duration instruments, where rising interest rates are a clear negative for returns, rising interest rates aren’t necessarily harmful to real assets like real estate. Investors should consider:

  1. To what extent an increase in nominal interest rates is accompanied by a corresponding increase in real interest rates and,
  2. To what extent an increase in cap rates is offset by higher rents that produce higher NOI growth.

Rising interest rates may cause a rise in cap rates, but this is not definitively the case. There are many recent examples where interest rates have risen and cap rates have compressed, including the current environment: over the five quarters ending Q3 2021, long-term interest rates have more than doubled, rising by more than 70 basis points (bps) while cap rates for the industrial and multifamily segments have compressed by roughly 50 bps and 75 bps, respectively, over the same period. Other examples of a prolonged upward rise in interest rates include 2003-2006, 2012-2013 and mid-2016-2018, where 10-year U.S. Treasury yields rose by more than 100 bps each time, even as cap rates remained flat or compressed.
Investor demand plays into the direction of cap rates, particularly against the backdrop of real estate’s relative attractiveness to other sectors such as corporate debt. Cap rates will frequently show a greater sensitivity to corporate bond yields than nominal interest rates directly, suggesting that the credit component of real estate (including prospects for tenant demand and NOI growth) is more critical than where we are in the business cycle.

In addition to any transmission of higher interest rates to higher cap rates, investors should be mindful that assets with shorter lease duration can serve as an attractive hedge to rising price pressures, particularly if landlords are able to re-lease properties at higher market rents. Overall, since the inception of the NCREIF Property Index (NPI), the correlation between rolling annual returns and rolling headline inflation  is 0.43, suggesting that high inflation does indeed correspond with higher returns.

Lastly, we note that rising cap rates are a positive for capital redeployment; cash flows from current income can be reinvested into projects with higher entry cap rates, leading to higher income growth. With the U.S. set to be one the first central banks likely to raise rates, higher interest rates could continue to encourage global capital to enter the sector, dampening any upward pressure on cap rates that would otherwise occur.