The recent remarks by Federal Reserve Board Chairman Alan Greenspan that policy makers are “prepared to do what is necessary” to curb inflation makes clear that interest rates may rise more quickly than previously believed. Real estate investors who follow the traditional rule that capitalization rates follow the direction of interest rates are likely to be concerned that this will mean real estate values will plummet. But a close look at the relationship between the two rates during the past four years indicates that this may not at all be the case.

Traditional View

The traditional argument that the spread between interest rates and cap rates remains within a relatively narrow band is based on the belief that real estate values are strongly influenced by the cost of financing. Lower loan costs mean that investors can achieve their desired internal rate of return over a projected holding period at a higher purchase price. As a result, real estate market values rise (cap rates decline) as buyers compete for desirable properties. During the recent period of extremely low interest rates, cap rates appeared to reach record low levels (prices appeared very high), seemingly confirming this belief.

On the other hand, when interest rates rise, the opposite result is assumed to occur. Higher borrowing costs mean less upside leverage, so prices will decline (cap rates will rise) if buyers are to achieve the desired IRR over their holding period.

Another View

A study of interest rate and cap rate changes over the past few years suggests that a sharp drop in real estate values is not necessarily in the card – because prices never rose as high (cap rates did not decline as much) as many people believed.

At the end of the second quarter of 2000, the 10-year Treasury note, against which cap rates usually are compared, was 6.02 percent. At the end of the first quarter of 2004, the Treasury rate had dropped to 3.84 percent, a decline of 218 basis points. Over the same period of time, cap rates for five major real estate sectors also declined—but by far fewer basis points (bp). Put another way, although interest rates and office building cap rates both moved lower, the spread between them widened very substantially. Had cap rates dropped as much as the UST10, office-building prices would have gone through the roof. The widening of spreads in 2003, when the extraordinary drop in interest rates occurred, meant that most investors were unwilling to pay the much higher prices that would have resulted by valuing property using lower cap rates. Instead, prices “hit a wall.”

Normal Spreads

Other research suggests that normal spreads between Treasury rates and investment real estate range between 200 and 300 bp. Thus, when the UST10 is 6 percent, cap rates (yields) range between 8 and 9 percent—rates that frequently are cited as those occurring in normal markets. Mortgage financing at lower interest rates then can raise the leveraged return by several percentage points.

Who Was Buying?

In the sometimes frenzied markets of the past two years, a significant number of buyers accepted property valuations at 6 or even 5 percent cap rates, which meant spreads of 200 or 300 bp over then Treasury rates of 3 to 4 percent. In short, they were purchasing real estate at very high prices. Some undoubtedly were opportunistic buyers who expected to flip properties at even higher prices. Others might have been non-publicly traded REITs forced to put cash to work as investors transferred funds from a collapsing stock market. Since the private REITs often buy properties for all cash or with minimal financing (less than 50 percent loan-to-value), they are less sensitive about the possibility of downside leverage if mortgage rates exceed the REIT’s going-in cap rate. Foreign investors also often buy for cash or with very small mortgages. Finally, some buyers may have convinced themselves that a property’s net operating income (NOI) would rebound promptly as the economy improved, thus raising their yields to more normal levels.

Summing Up

Based on the above analysis, it appears that real estate values did not stray as far from normal levels as some had feared. Experienced buyers as well as lenders apparently were unwilling to push cap rates below a certain point regardless of how far interest rates fell. When buyers did make offers that “could not be refused,” sellers accepted but often with the intention of re-entering the market when prices dropped, thus providing future support for a falling market. In short, cap rates follow interest rates but only up to a certain point beyond which other considerations are paramount.