Summer Street Advisors


       


Thursday
Aug292013

Three Reasons Why Treasury Rise Might Not Affect Cap Rates

The real estate investment community took note of the recent 100-basis-point rise in 10-year Treasury rates. Some investors may have briefly hit the ‘pause’ button on deals when the increase was at its steepest slope. But so far, it seems that the narrowing spread between Treasuries and cap rates –not to mention the sharp increase in interest rates-- has not had much of an effect on commercial real estate values. 

That could change, of course, especially if the Treasury rate continues to rise, but it’s not surprising that the market’s reaction to date has been muted.  Here are three factors that help explain why:

  • Spreads were historically wide before.   For a while, Treasuries were so low that cap rates could not follow.  Some investors may have assumed Treasuries would rise – they certainly couldn’t fall any further – and built wider spreads into their models. Even now, spreads are about 20 percent higher than average of the past two decades.
  • Fundamentals are improving.   For the past few years, the outlook of real estate markets have been uncertain, and investors focused on risk-adjusted yields as much as more than spreads over Treasuries. Now, occupancy rates are improving in most markets. With little new supply, there’s reason to be optimistic that rents will start to rise.  Investors may be willing to accept a lower going-in cap rate if they are confident that cash flows will increase.
  • There’s a lot of money that has to land somewhere.  Real estate markets are awash in capital.  With the recent reminder of downside risk, investors are cautious, so a lot of capital hasn’t found a home.  Narrower spreads won’t shift all that money to lower-yield assets just because they’re less risky. And interest rates don’t matter much to investors that don’t intend to leverage assets anyway—they’re looking for a place to put money, not a way to borrow more.