Real estate pricing: Short-term view needs long-term perspective

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 paper will address: 

1. Why a long-run view is needed: Demonstrate why we believe the dynamic nature of real estate cap rates calls for a long-run intrinsic value approach to understanding cap rates.
2. Develop a long-term range: Present step-by-step assumptions to build a range of future long-term average real estate cap rates.
3. Compare our long-term view to current cap rates: Use the long-term average range and current market average cap rates per sector as proxies for comparing potential exit cap rates to potential acquisition cap rates.

Why a long-term view is needed

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. 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). 

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.

Building up a long-term range

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.

• As stated, the FOMC median forecast for the longer-run Fed Funds rate is 2.5%.³
• The long-term average spread between the Fed Funds rate and the 10-year US Treasury yield has been roughly 150 basis points since 1990.
• The long-term average spread between the 10-year Treasury yield and institutional real estate valuation cap rates has been about 200 basis points since 1990.⁴
  • The range of the spread between average cap rates and the 10-year Treasury yield since 1990 typically has been +/- 130 basis points. That typical range has narrowed over time since 2000 to +/- 100 basis points.
• Taken together, these inputs solve to an assumed exit cap rate of 6.0% on a long-term average basis.
  • Applying a 100-basis-point spread to either side of the long-term average results in a long-term primary range of 5.0% (during times of stronger capital flow momentum) to 7.0% (during times of weaker capital flows).

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.

Long-term potential exit vs. current potential transactions¹

Our build-up approach for long-run for exit cap rates gives us context for considering current market cap rates per sector.

Let's consider some interpretative rules-of-thumb and some observations:

Rules of thumb:

• Sectors that post current cap rates on the lower end or below the primary long-term range would need to provide outsized growth of property incomes to justify a lower cap rate.
• Sectors that post current cap rates on the upper end or above the primary long-term range would need to be analysed to determine whether the higher cap rate represents attractive relative value or instead reflects a higher level of risk.

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.

Conclusion

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.