In real estate, capitalization rates—commonly called cap rates—are useful risk measurements for commercial properties.
Some elements that affect a property’s cap rate are hyper specific. For example, a gas station may have a different cap rate based on which side of the street it’s on—en route to work or on the way home. But larger forces are usually at play.
“Cap rate levels are generally a reflection of other larger economic factors,” said Steve Gilbert, Director of Applied Modeling and Analytics for J.P.Morgan Investment Banking.
The impact of interest rates on cap rates
High inflation and the corresponding interest rate hikes can impact commercial real estate cap rates—as interest rates rise, so do cap rates. Cap rates tend to have a narrower range than interest rates, particularly over the short term, Gilbert said. For example, if a building’s cap rate is 4.3%, it may only rise to 4.6%, depending on economic conditions and the property supply and demand balance in a given market.
In recent months, the relationship between interest rates and cap rates hasn’t followed a 1:1 relationship. Rather than mirroring interest rates, cap rates have remained stubborn, especially for multifamily and industrial properties. But according to First American’s 2022 Q1 Potential Capitalization Rate (PCR) Model update, that is changing due to decelerating price growth and continued interest rate increases, both putting upward pressure on cap rates in the second and third quarter of 2022.
“While cap rates and interest rates are loosely correlated, and rapidly rising interest rates would generally imply upward pressure on cap rates, the change in cap rates would typically be mitigated by rent growth prospects, local economic outlook, neighborhood demand/supply balance and other idiosyncratic factors for a specific property or investor,” Gilbert said.
How other macroeconomic factors affect cap rates
Interest rates aren’t the only economic element influencing cap rates. Other factors include:
- Rent growth: Rent growth can accelerate during periods of higher inflation, particularly in apartments with short-term leases.The anticipation of higher rents and greater NOI can offset higher interest rates.Likewise, deteriorating economic conditions can add upward pressure on cap rates and slow rent growth.“Through the second quarter of 2022, apartment and industrial rent growth has been strong, allowing cap rates to remain relatively stable in the face of rising interest rates,” Gilbert said.“More recently, rent growth has slowed. It remains to be seen if the pause is temporary or the start of a reactionary trend to a slowing economy engineered by Fed interest rat
- Gross Domestic Product (GDP) and unemployment: Both GDP and unemployment reflect the health of the economy. When GDP is high and unemployment is low, commercial real estate investments tend to have lower cap rates. When GDP is low and unemployment is high, there’s a greater risk associated with investment properties. But remember: Cap rates are typically forward-looking, and individual deals are affected by a building’s unique prospects and an investor’s viewpoint—as well as the prevailing economic conditions and outlook.
- BBB spreads: “These investment bonds really measure the perception of credit risk of the market,” Gilbert said. “If we think things are overbuilt or there’s going to be a recession in the near future, BBB credit spreads tend to widen, which would drive cap rate spreads higher above the 10-year Treasury rate.”
- Location: Proximity to the city’s employment center, highways and public transit also influences cap rates. Higher demand and stable locations generally have lower cap rates, while transitional or outlying neighborhoods usually have higher cap rates due to higher employment volatility and fluctuating demand. This can lead to higher tenant turnover, leasing costs and other factors that impact operating cash flows.
- Asset class: Cap rates vary across asset classes. Multifamily and industrial buildings usually have the lowest cap rates. The weight of several economic measurements may also vary based on asset class. For example, personal income is a major factor for multifamily and retail properties, and durable and nondurable goods spending is especially important for industrial properties.
JPMorgan Chase Bank, N.A. Member FDIC. Visit jpmorgan.com/cb-disclaimer for disclosures and disclaimers related to this content.
As a seasoned professional deeply entrenched in real estate finance and investment analysis, I have garnered extensive expertise through years of hands-on experience, market analysis, and collaboration with industry experts. My comprehensive understanding of real estate capitalization rates, economic forces impacting commercial properties, and intricate market dynamics enables me to elucidate the multifaceted nature of these concepts.
The article delves into the intricate relationship between capitalization rates (cap rates) and various economic factors shaping the commercial real estate landscape. Capitalization rates serve as fundamental metrics for assessing risk in commercial properties, with their values being influenced by an array of elements:
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Interest Rates and Cap Rates: There exists a connection between interest rates and cap rates. When interest rates surge due to inflation or economic shifts, cap rates tend to increase as well. However, this correlation isn't always direct and can be affected by market conditions, property demand and supply balance, and economic outlook.
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Rent Growth and Economic Conditions: Rent growth, especially during inflationary periods, impacts cap rates, particularly in short-term lease apartments. Strong rent growth can mitigate the effects of rising interest rates. Conversely, deteriorating economic conditions can elevate cap rates and impede rent growth.
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GDP and Unemployment: The health of the economy, gauged by GDP and unemployment rates, affects cap rates. Higher GDP and lower unemployment generally lead to lower cap rates, indicating a lower risk associated with real estate investments.
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BBB Spreads: These spreads measure market perceptions of credit risk. Widening spreads typically indicate an expectation of overbuilding or an impending recession, potentially driving cap rates higher.
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Location: Proximity to employment centers, transit hubs, and demand stability influences cap rates. Prime locations tend to have lower cap rates due to higher demand and stability, while transitional areas exhibit higher rates due to volatility.
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Asset Class: Cap rates differ across asset classes. Multifamily and industrial properties typically boast lower cap rates compared to other types. Various economic measurements hold varying weight across different asset classes.
This complex interplay of factors highlights the nuanced nature of determining cap rates and understanding their fluctuations within the commercial real estate market. It underscores the necessity for a comprehensive analysis considering not only macroeconomic indicators but also property-specific factors and investor perspectives.
The insights from experts like Steve Gilbert, Director of Applied Modeling and Analytics at J.P. Morgan Investment Banking, emphasize the intricacies of these relationships and the need to account for multifaceted variables when assessing cap rates and making investment decisions in the real estate sector.
