February 27, 2017
EXECUTIVE SUMMARY
- We have been following interest rate movement closely and have concluded that the spike in the 10-year Treasury will have minimal short-term impact on cap rates. For 2018, we believe cap rates will be flat to slightly up, with more upward pressure likely in 2019.
- Our viewpoint is informed by discussions with CBRE professionals in Americas Research, Capital Markets, Valuation & Advisory Services and Financial Consulting, as well as our clients. A more complete summary of these discussions is available upon request.
DISCUSSION
- The 10-year Treasury yield has increased by 80 bps to 2.85% since September 2017 and we expect it will rise further to 3.0% before levelling off through 2019 (CBRE EA forecast).
- Other Wall Street economists predict a higher peak. Example: Goldman Sachs pegs the peak at 3.5% in 2019.
- Cap rates are expected to stay flat or rise slightly in 2018 due to the increase in the cost of debt, but the rate of expansion will depend on market and asset type.
- Geographic markets with greatest rent growth will be most resilient.
- Industrial, with the strongest investor demand, will be generally more resilient than other asset types.
- Retail showed the greatest weakness in cap rates last year, even before interest rates began to rise. Recent increases in interest rates may cause cap rate expansion in retail to accelerate for secondary/weaker assets.
- Secular factors, particularly the strength of equity capital flows, have upended the historic relationship between interest rates and cap rates.
- Historically, cap rates rarely rise absent a big fall in aggregate demand and rise in unemployment.
- For foreign capital flows, the fall in the dollar is a big offset to rising interest rates. And CBRE’s recent surveys suggest that the U.S. is the top destination for global capital in 2018.
- There most likely will be little change in cap rates in 2018, despite rising interest rates. A modest rise in cap rates is more likely in 2019.
- Investors are increasingly trying to re-trade deals that are under contract or non-refundable. This is a typical reaction when interest rates spike. Most recently, 75% of deals that were under contract or non-refundable had no price adjustment when interest rates rose in late 2016, and those that did have a price adjustment averaged 3% of deal value.
- Borrowing costs have gone up by 25 to 35 bps across the yield curve in 2018, as the 50+ bps move in Treasurys has been partially offset by a 25-bps tightening of spreads between the base rate and the borrowing rate (which varies by LTV and term).
- Some assets have been particularly hard hit, as interest rates on Class B office have increased by 50 bps in the last few weeks alone.
- There have been some mixed signals from publicly traded real estate:
- The Baa bond spread to real estate returns ratio is near to its historic average (indicating stability).
- Public REIT prices have materially weakened in line with the rise in interest rates, with implied NAVs well below private market values (indicating cap rate weakness).
CBRE is monitoring interest rate movement closely through both a top-down (econometric) and bottom-up basis (facts on the ground) and we will issue updates as market conditions warrant. Please reach out to any of the professionals listed below if you would like to discuss further.
