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Commercial Real Estate Pricing during past Fed Tightening Cycles.

The year has been undoubtedly a watermark for the commercial real estate market in terms of record sales. Given the Fed’s likely decision to begin tapering of asset purchases in reaction to accelerating inflation above their two percent target, we will likely see the end of the accommodative monetary policy brought on by the Covid 19 pandemic.  In this blog post, we will dive into how capitalization rates have trended in relation to Fed monetary tightening cycles and how their spread has performed relative to the 10-Year U.S. Treasury Note.

Source: CoStar & FRED

2021 Cap Rate Spreads over 10 Year US Treasury

Source: CoStar & FRED

It is common practice in commercial real estate to use the 10-year U.S. Treasury Bond Yield as the risk-free rate. The capitalization rate is an investor’s potential rate of return determined by dividing the net operating income by the current market value. The chart above depicts the spread between the capitalization rates of the four major property types and the 10-Year U.S. Treasury Note yields as far back as CoStar provides data. This spread reflects the risk and return relationship between purchasing a treasury note and a commercial real estate property. The capitalization rate spreads over the past year can be seen in the table above.

As it is seen above, spreads have widened significantly since the 1980’s recession. A possible reason for the negative spreads seen in the 1980’s was due to tax reforms on the use of real estate as a tax shelter. Excluding the 1980’s figures, the spread has historically ranged between approximately four and five percent.

One relationship that can be seen above is the slight compression of spreads as the Fed begins monetary tightening and the lag in the increases of capitalization rates across property types. As the Fed increases rates, you can most notably see the spread compression in the 1994 and 2004-2006 monetary tightening cycles. It can also be noted from the table above that the capitalization rate spreads of each property type are significantly correlated exhibiting similar risk and return relationships with interest rate moves.

A factor that could create spread compression once again is the relative weakness of the global economy in comparison with the United States. As seen in 2021, foreign investors rolled back into the U.S. commercial real estate market spending $70.8 billion according to Real Capital Analytics. This is double what was seen in 2020 and the highest overall total since 2018 when foreign investors purchased $94.6 billion of U.S. commercial real estate. This tied with job growth and inflation expectation could tighten this capitalization rate spread to historical norms.

It should be noted that the commercial real estate market is fairly complex and pricing is impacted by a number of variables aside from interest rates.  That being said, the above relationship can show a basic reflection of what could be expected of future pricing based on past tightening cycles.

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.

 

Trenton Joyce

Vice President, Acquisitions
Boyd Watterson Asset Management, LLC