For investors in commercial real estate (CRE), cap rates are a key metric. They offer insights into the expected rate of return, helping assess whether an investment is financially viable. But cap rates don’t exist in a vacuum; they’re deeply intertwined with the broader economic landscape, particularly with bond yields such as the 10-Year Treasury.
Understanding the Basics of Cap Rates and the 10-Year Treasury Yield
The capitalization rate, or “cap rate,” is calculated by dividing a property’s annual net operating income (NOI) by its current market value. A lower cap rate indicates that the property is trading at a higher price relative to its income, often signaling lower risk, while a higher cap rate suggests greater income relative to price but potentially more risk.
The 10-Year Treasury yield, meanwhile, is often considered the “risk-free” rate in U.S. investments, as it’s backed by the federal government. This yield is a benchmark for setting borrowing costs and expectations for long-term economic trends, influencing various sectors, including real estate. Investors in CRE watch it closely, as it serves as a guide to assess the relative risk and returns of other investments.
Why the 10-Year Treasury Yield Matters in Commercial Real Estate
The 10-Year Treasury yield is like a financial heartbeat for the U.S. economy. Rising yields typically reflect market expectations of higher inflation and stronger growth, while falling yields suggest the opposite. In CRE, the yield on Treasuries acts as a barometer against which investors measure the attractiveness of real estate returns.
When the 10-Year Treasury yield rises, it becomes more expensive to borrow, which can lead investors to demand higher cap rates on commercial properties to justify the increased opportunity cost of investing in real estate over bonds. Conversely, lower yields often mean cheaper financing and a lower “risk-free” return on bonds, making real estate returns more attractive even at lower cap rates.
Cap Rates and Treasury Yields: The Spread
The “spread” between the 10-Year Treasury yield and commercial real estate cap rates is a critical factor for investors. Essentially, it’s the difference between the two, often referred to as the risk premium in CRE. For example, if the 10-Year Treasury is at 3% and CRE cap rates are around 6%, there’s a 3% spread, which compensates investors for the added risk in real estate over Treasury bonds.
This spread, however, fluctuates depending on market conditions. When Treasury yields rise without a corresponding increase in cap rates, the spread narrows, potentially leading to decreased real estate investment as investors shift to more stable Treasury securities. Conversely, if cap rates rise while Treasury yields stay flat or decline, the spread widens, often attracting more investment to the potentially higher returns in CRE.
The Impact of Rising Treasury Yields on Cap Rates
In periods of rising Treasury yields, the risk-free rate increases, causing lenders to raise borrowing costs for commercial real estate. This situation pushes cap rates upward, as investors demand higher returns to justify the risk and opportunity cost. When yields are high, real estate properties must promise higher returns to remain competitive.
However, the relationship between yields and cap rates isn’t always direct. While there’s often a strong correlation, several mitigating factors influence whether cap rates will rise in step with Treasury yields, including:
- Supply and Demand for CRE: High demand for commercial properties can keep cap rates low even in a rising yield environment.
- Market Sentiment and Risk Appetite: In “risk-on” environments where investors are willing to take on more risk, cap rates may remain lower, as they see real estate as a viable long-term investment despite higher yields.
- Type of Commercial Property: Different asset classes (such as office, retail, or industrial) respond uniquely to shifts in yields, driven by their respective market dynamics and investor demand.
For instance, during times of economic optimism, investors may continue to view CRE favorably despite rising yields, believing that stronger economic growth will ultimately benefit property values and income.
The Role of Monetary Policy in the Relationship
The Federal Reserve’s monetary policy, which heavily influences Treasury yields, plays an enormous role in shaping cap rates. During periods of low interest rates, like those seen after the 2008 financial crisis and the COVID-19 pandemic, the Fed’s policies pushed down Treasury yields, helping to keep borrowing costs low. In such an environment, investors grew comfortable with lower cap rates, especially as alternative yields became more limited.
However, when the Fed signals rate hikes, as seen in 2022 and beyond, Treasury yields begin to rise, altering the investment landscape. CRE investors closely watch these rate hikes as they foreshadow increases in cap rates, driven by higher borrowing costs and the changing attractiveness of alternative investments.
Economic Cycles and Their Influence on the Relationship
The relationship between the 10-Year Treasury yield and cap rates isn’t just a static figure; it fluctuates with economic cycles. During times of economic downturn, Treasury yields tend to fall as investors flee to the relative safety of government bonds. This drop in yield often leads to lower cap rates, especially if central banks are also pushing rates down to stimulate the economy. Conversely, in an economic boom, yields rise as investors become more confident, often increasing cap rates as a result.
Yet this relationship can sometimes reverse in times of crisis. For instance, the COVID-19 pandemic saw the 10-Year Treasury yield plummet, but certain types of CRE properties, particularly retail and office spaces, faced upward pressure on cap rates due to concerns about future income stability. This example underscores how the relationship can vary based on the nature of the economic event and investor sentiment.
Understanding Cap Rate Compression and Expansion
When the spread between the 10-Year Treasury and CRE cap rates narrows, we refer to it as “cap rate compression.” This often happens in low-yield environments where investors are willing to accept lower cap rates because the alternative yields on “risk-free” securities like Treasuries are also low. Cap rate compression is common in bull markets, as demand for CRE outpaces supply, and investors view properties as safer, stable assets in uncertain markets.
On the flip side, “cap rate expansion” occurs when the spread widens. This typically happens during periods of rising yields and/or economic uncertainty, as investors seek higher returns for the risk associated with real estate. Cap rate expansion can signal weaker demand for commercial properties, as investors shift to safer or more lucrative investments.
Current Trends and Looking Forward
In recent years, the CRE market has seen heightened interest as investors sought alternatives to low-yield bonds. However, with recent increases in the 10-Year Treasury yield as of late 2022 and beyond, there are signs that this trend may shift. Investors may start demanding higher cap rates to justify their investments as borrowing costs rise and Treasury yields become more attractive.
However, the picture is nuanced. Different CRE segments respond differently to changes in Treasury yields. For example, industrial real estate and multifamily housing have shown resilience due to strong demand fundamentals, keeping cap rates relatively stable. Conversely, sectors like retail and office spaces are more sensitive to yield changes, as they face structural shifts in demand patterns.
Conclusion: A Symbiotic Yet Shifting Relationship
The relationship between the 10-Year Treasury yield and CRE cap rates is like a finely tuned dance, with each partner influencing the other. Rising Treasury yields generally lead to higher cap rates, as investors weigh the opportunity costs. But economic conditions, supply-demand dynamics, and property-specific factors all play a role in determining how closely cap rates will follow yield movements.
As we look to the future, investors should keep an eye on Treasury yield trends and the Fed’s policy directions. For those in the CRE sector, understanding this relationship is crucial for making informed investment decisions and anticipating how shifts in the broader economic landscape may impact the profitability of their portfolios. Though complex, this interplay offers a fascinating insight into how financial markets and real assets intersect in a continually evolving economy.
About the Author: Stan Wood, CCIM is the Managing Member of WINPRO Wealth Management, LLC (WINPRO). WINPRO offers several Reg D. Private Credit platforms tailored to meet investors’ needs and objectives. For more information about WINPRO, please visit us at www.winprofunds.com, or give Stan a call at 720.344.1174.