Cap Rate Spread

What is the Risk Premium in the Cap Rate Spread?

In the financial markets, the 10-year Treasury yield is a critical indicator of the current state of the economy and outlook on near-term economic conditions.

Since bond prices and yields are inversely related, negative sentiment among investors and fears of a coming recession cause capital to flow into risk-free government bonds.

The sudden rise in demand for U.S. government bonds as investors flock to allocate their capital to safer fixed-income issuances by the government is an increase in bond prices and a steep drop-off in yields.

Given that property investments are risky assets – contrary to government bonds backed by the “full faith and credit” of the U.S. government – the cap rate spread measures the difference between the cap rate of real estate properties and the yield on the 10-year Treasury note to function as an indicator of risk.

• Risk-Free Securities (rf) → Government bonds such as the 10-Year U.S. Treasury notes are considered risk-free; hence, the security is used as the “risk-free rate” in valuation analysis, most notably the DCF model.
• Real Estate Investments →In contrast, real estate investing strategies such as acquisitions and development projects are perceived to carry far more risk. The difference between the estimated return on a property investment and the U.S. 10-year Treasury yield reflects the concept of the risk premium.

Cap Rate Expansion vs. Cap Rate Compression: What is the Difference?

Historically, the cap rate spread has exhibited a tendency to expand in times of economic turmoil, while decreasing in periods of robust economic growth and stability.

The periodic directional shifts in the market cap rates are described using the following two terms:

• Cap Rate Expansion → If the delta between the yields on the 10-year Treasuries and the cap rate widens – which occurs in periods referred to as “cap rate expansion”, where cap rates rise – the value of properties declines.
• Cap Rate Compression → On the other hand, if the spread reduces amid a state of cap rate compression, each dollar of net operating income (NOI) generated by properties is worth more (and thus property values increase).

Why Does the Cap Rate Spread Matter?

By closely monitoring the trends in the cap rate spread – i.e. tracking the constant fluctuations in the percentage increases and decreases – commercial real estate investors (CRE) and institutional lenders that underwrite commercial loans can develop a more in-depth understanding of the current macro conditions in the economy.

However, the movements in the cap rate spread by themselves are not sufficient to influence investment or lending decisions, akin to the inverted yield curve.

The volatility in the spread should instead be interpreted as a potential risk that the market is currently in a state of uncertainty. Because of that risk, the investor or underwriter should perform in-depth diligence to identify the underlying causes and figure out the best course of action in terms of mitigating risk.

The cap rate spread is an indicator of potential economic risk for real estate investors and loan underwriters, which can influence the operating performance of the property (i.e. the asset securing the loan).

One use case for determining the cap rate spread is to estimate the current stage of the market cycle.

Higher spreads coincide with a declining market and could be a red flag that the economic conditions and state of the market is at risk of worsening.

• High Cap Rate Spread → Generally, a higher cap rate spread implies the economy is likely underperforming, and will continue trending downward. But there are certainly exceptions to the rule, per usual.
• Low Cap Rate Spread → Conversely, a low cap rate spread tends to coincide with periods of economic stability, positive growth, and an optimistic near-term outlook among investors.

With regard to the implications of measuring the recent cap rate spread, investors might prefer a fixed interest rate structure if there is substantial market volatility.

Conversely, if the cap rate spread is low with minimal volatility, the investor might request an adjustable-rate loan, i.e. the interest rate pricing is variable.

Cap Rate Spread Example: U.S. Fed Monetary Policy (2023)

For instance, the Federal Reserve (Fed) started to unwind its prior monetary policies and shrink its balance sheet around mid-2022 as the U.S. economy gradually normalized.

The issue? The Fed now had to combat the inflation caused by their aggressive monetary policies and quantitative easing (QE) amid the COVID-19 pandemic.

However, the release of concerning economics data pertaining to rising inflation (and the risk of hyperinflation) caused the Fed to quickly step in to prevent an economic crisis and collapse into a long-term recession.

The interest rate hikes used to reduce inflation also increased the cost of borrowing – which, as we mentioned earlier, causes cap rates to expand and demand from buyers in the market to decline.

Therefore, the announced interest rate hikes and subsequent cap rate expansion in the U.S. was a predictable outcome, yet where the real estate market currently is in its cycle and if the peak is near remains the topic of much speculation as we enter 2023.

^{“Underwriting Assumptions Exceed Pre-Pandemic Levels for Prime Multifamily Assets” (Source: CBRE)}