GUEST COMMENTARY: A complicated relationship

 As we make our way toward a tightening of US monetary policy, discussions surrounding rising interest rates and their impact on cap rates are increasing at a pace far greater than the interest rate increase itself. The relationship between interest rates and cap rates is not that simple. It revolves around the economic environment which influences short-term rates and Fed policy; changes in short-term rates which may or may not be transmitted into long-term rates; and only then, will changes in long-term rates possibly be reflected in cap rates.

To get the real picture, you need first to differentiate between changes in short and long-term rates and only then can you assess what impact there will be on cap rates.

Short-term rates

Monetary policy actions control short-term rates and in doing so, the Fed looks to changes in the US economic health to determine the timing of such actions.

While the US is doing relatively well economically, global financial markets have become increasingly unstable, led by concerns surrounding both economic growth in China and that country’s skill at financial market liberalization.

Not surprising, inflation pressures are low and unlikely to become a reality anytime soon.

As a result, Fed action remains somewhat constrained in the near-term by this increased market volatility as well as questions surrounding global economic growth, a rising dollar, and an inflation target that remains ever more of a goal than a reality. So, while the Fed would like to raise short-term rates materially before the next recession, all of these factors collectively will likely force it to slow its pace of rate normalization, making the near-term magnitude of any policy action more symbolic than material.

Long-term rates decouple from short-term rates

When Fed policy does change, the popular assumption is that all interest rates will increase; however, this isn’t necessarily the case. Short-term and long-term rates are driven by different factors. Short-term rates are influenced disproportionately by expected and actual Fed policy, while long-term rates are moved more by factors such as global growth, financial market stability, and foreign central bank policies.

The current divergence in short-term and long-term rates reflects the divergence between the US economy and those overseas. The market expects the Fed to eventually increase short-term rates. Conversely, the market sees increased risks to global growth, financial market stability and lower sovereign debt yields. This decoupling has pivotal implications for divining the future of commercial real estate cap rates.

Long-term interest rates are only once piece of the cap rate puzzle

The spread between 10-Year Treasury rates and commercial real estate cap rates is currently 426 basis points, compared to the long-term average of 350 basis points and the most recent cycle’s low of 101 basis points. At the current spread, and based on today’s interest rate assumptions, we do not see a significant increase in cap rates resulting from rising interest rates.

That said looking only at interest rates can give investors a false sense of security regarding the future path of cap rates. Investors would also be prudent to look at both the sustainability of investor sentiment toward commercial real estate and a potential market-wide shift in investor sentiment toward risk.

The greatest potential threat to cap rates would be a widespread shift in investor sentiment toward risk premiums, especially if investors shift toward extremely conservative investments such as cash and high quality fixed income investments. The likely catalyst for this would be a reaction to a financial instability event, such as a severe and sustained decline in equity values, a currency crisis, the revelation of malinvestment similar to the subprime mortgage crisis, a surprising decline in Chinese economic growth, another factor or some combination of these.

So, while Fed policy has a significant effect on short-term rates, it does not always impact long-term rates or for that matter real estate cap rates. Rather, it is investor sentiment and related capital flows that will likely have a greater impact on cap rates, and this depends on future financial market and global economic developments.

Where does this leave investors?

In a world of increasing uncertainty and elevated pricing, one should assume a defensive posture and now more than ever assess returns in light of both returns and associated risks. While there are times to focus on outsized gains, this is not one of those times. 

With the risk of an economic slowing or a financial instability event being greater than the likelihood of outsized economic growth and a significant increase in interest rates, now is a time we recommend taking a defensive posture.

Stanley Iezman is chairman and chief executive, while Christopher Macke works as managing director of Research & Strategy at American Realty Advisors, a Los Angeles-based real estate investment manager.