One of the hottest questions posed today by real estate investors is, "Where will cap rates eventually settle after they peak?" This question is difficult because it's flawed -cap rates don't settle; they are dynamic, transitioning from one period to the next, quarter after quarter, year after year. While the need to project short-term cap rate movements is necessary to making investment decisions, the dynamic nature of cap rates also calls for a longer-term view of cap rates to provide context for any short-term outlook. With those thoughts in mind, this article will address:
One only needs to look at the dynamic historical movement between cap rates and related base rates to appreciate why we believe a short-term future view about cap rates must be augmented with a long-term outlook. Let's start by looking at the past three decades' interaction of real estate cap rates with a couple of important base interest rates, the Fed Funds rate and the 10-year US Treasury rate (see Figure 1). Risk assets including real estate are typically priced as a spread over a base rate, like a Treasury yield. And the 10-year Treasury yield has historically exceeded the Fed Funds rate on average. The times when spreads among these rates compress tightly or invert are typically associated with weakening economic conditions and value erosion (e.g., the early 1990s prior to financial market restructuring; late 1990's prior to the tech bust; mid-2000's prior to the Global Financial Crisis; late 2010's coincidentally prior to the onset of COVID; and the 2022-present rate response to outsized inflation).
Sources: Invesco Real Estate, utilizing data from NCREIF, Moody’s Analytics, and the Federal Open Market Committee as of January 2024.
Past performance is not a guarantee of future results. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations.
Historically, these periods of convergence and inversion have represented breaks from the norm. Convergence and inversion don't tend to be sustained over time; rather, they represent a transition in time. The factors that lead to convergence or inversion eventually get resolved, and positive spreads between the rates are eventually restored for several years, until the next break from the norm. Also, the time between one convergence period to another has varied, driven by the unique factors at play during each period.
The dynamic nature of rates and spreads, and the time variability of when spreads widen or contract, complicates the task of forecasting the short-term movement of cap rates. Yet, such forecasts are used to form exit price assumptions for real estate transactions and valuations of held assets.
The inherent challenges with near-term period-by-period forecasts could benefit enormously from a long-term perspective. So, we start with base rates. Over the long run, the Federal Open Market Committee's (FOMC) median projection for the Fed Funds rate2 is 2.5%. Starting with this long-run Fed Funds rate assumption, we can develop a long-run view about Treasury yields and real estate exit cap rates.
Our thinking about long-term exit cap rates starts with a long-term view about Fed rate policy and applies historical average spreads to that base (see Figure 2):
Sources: Invesco Real Estate utilizing data from NCREIF, Moody’s Analytics, and the Federal Open Market Committee as of January 2024. The results shown are hypothetical (not real) and were achieved by means of the retroactive application of the statistical model. It may not be possible to replicate the hypothetical results. There is no guarantee these assumptions will be realized.
Based on these assumptions, we can estimate long-term exit cap rates for commercial real estate to average about 6.0%, and for that average expected long-term cap rate to move mostly between 5.0% to 7.0%, depending on prevailing market conditions.
So, where are the potential flaws with this build-up approach for a long-term cap rate assumption? For starters, maybe the Fed Funds rate will average higher than 2.5% over the long run; or it could average lower. Maybe the spread relationship between the Fed Funds rate and the 10-year Treasury yield could change. Maybe the spread relationship between the Treasury yield and cap rates could change if long-term capital flows accelerate or decelerate. Each of these points is worth consideration. And the simplicity of this build-up approach easily allows for using alternative assumptions to consider a range of outcomes.
For purposes of this note, we'll use the 6.0% average assumption and the 5.0%-7.0% range as a baseline long-term outlook to compare against current cap rates.
Our build-up approach for long-run for exit cap rates gives us context for considering current market cap rates per sector (see Figure 3).
Sources: Invesco Real Estate, utilising data from Green Street, NCREIF, Moody's Analytics, and the Federal Open Market Committee as of January 2024
Let's consider some interpretative rules-of-thumb and some observations:
Overall: Of the 14 sectors shown on the chart, 9 sectors currently post cap rates within our assumed long-term primary range for all real estate, and cap rates for the other 5 sectors are outside the primary range.
Sectors within the range: Of those 9 sectors, 4 currently post cap rates below the 6.0% assumed long-term multi-sector average exit cap rate; 5 sectors currently post cap rates at or above the 6.0% long-term average.
Sectors above the range: Of the three sectors with cap rates above the primary long-term range, lodging has a volatile pattern of historical returns, and both malls and office are facing threats to long-run demand.
Sectors below the range: The two sectors with cap rates below the primary long-term range - industrial and single-family rentals - would need to provide outsized growth of property income to deliver returns that compete with or exceed the returns of sectors that are priced closer to the 6% multi-sector long-term average.
While a long-run view about real estate cap rates provides useful context for observing current cap rates, it's clear that additional information is required to make a holistic judgment about the appropriateness of current pricing per sector relative to long-term average values. Each sector must be evaluated for how tenant demand and future space supply are likely to influence property income growth. And sector cap rates must be adjusted to account for differences in capital expenditures.
That said, a long-run view about real estate cap rates provides the needed context for interpreting how current pricing, expected fundamentals, and capital spending relate to future investment returns. Like all investments, real estate investment decisions must consider multiple factors, and a long-run view about cap rates provides a foundation upon which to build all other investment assumptions.
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1 The proxy used for "current market average cap rates" is Green Street's sector average nominal cap rate. This cap rate represents the expected unleveraged first-year average yield that property buyers expect to realise on their investments. A nominal cap rate is calculated as: Nominal Net Operating Income (NOi) / Property Value.
2 The median forecast for the longer-run Fed Funds rate by the Federal Open Market Committee (FOMC) is represents each committee participant's assessment where the rate "would be expected to converge, over time, under appropriate monetary policy and in the absence of further shocks to the economy". (Source: FOMC Summary of Economic Projections, December 13, 2023)
3 The St. Louis Fed defines the FOMC "longer run" projections as follows: "The longer-run projections are the rates of growth, inflation, unemployment, and federal funds rate to which a policymaker expects the economy to converge over time in the absence of further shocks and under appropriate monetary policy. Because appropriate monetary policy, by definition, is aimed at achieving the Federal Reserve's dual mandate of maximum employment and price stability in the longer run, policymakers' longer-run projections for economic growth and unemployment may be interpreted, respectively, as estimates of the economy's longer-run potential growth rate and the longer-run normal rate of unemployment; similarly, the longer-run projection of inflation is the rate of inflation which the FOMC judges to be most consistent with its dual mandate in the longer-term." Per the September 20, 2023 FOMC projections, their "longer run" projections start after December 31, 2026.
4 Source: NCREIF (National Council of Real Estate Investment Fiduciaries). Data used is NCREIF's market-weighted current value cap rate from 01-1990 to 03-2023.
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