Rates and real estate
Capital is the lifeblood of the investment real estate industry. The availability and cost of that capital have a direct impact on the vibrancy of commercial real estate markets and values of properties. The relationship between the cost of capital, better known as interest rates, and the rental income rate from a property, known as a property’s capitalization rate (i.e., CAP rate), determines what return an investor will receive on their equity investment in a particular property. The CAP rate is the net income from an investment property divided by the cost of that property. The greater the spread between borrowing interest rates and CAP rates, the greater an investor’s return is likely to be on their equity investment
The outlook for interest rates in 2015 remains a bit fuzzy. The Federal Reserve has recently been sending signals to the capital markets that it intends to start raising short-term interest rates later this year in the wake of the strengthening U.S. economy. In a typical situation, higher short-term rates would translate into higher long-term rates because the risk for long-term lending is higher than short-term lending. Despite the Federal Reserve’s indication that higher interest rates are ahead, the markets seem to be pushing in the other direction.
The forecast of slowing growth in China and the talk of recession and deflation in Europe are pushing world interest rates lower. The contrast of slowing world economic growth versus talk of higher interest rates in the U.S. has resulted in a sharp increase in the value of the dollar against other currencies as world capital flows into the U.S. dollar and treasuries. In a few months, the euro has fallen roughly 18 percent against the dollar, and further declines are anticipated. In addition, the sharp drop in oil prices also signals a slowdown in the world economy again, translating into stable or lower interest rates worldwide.
Even if interest rates were to increase, it would likely be a modest increase in 2015 as a result of the slowing world economy. Such an increase would likely have only a mild impact on investment real estate. This is primarily because of the current relationship between market CAP rates and long-term 10-year Treasury rates. Since 1990, the spread between market CAP rates has ranged between 150 and 200 basis points on the low end and 480 and 580 basis points on the high end. The two times in the past 25 years when the spread was in the 150 to 200 point range was the beginning of 1990 and the end of 2006. Those were the two times just before the recession and commercial real estate collapse in the early ’90s and the Great Recession of 2007 to 2009.
Currently, the spread between the 10-year Treasury and the market CAP rate is about 450 basis points, which is about average during the periods of time in the past 25 years when the commercial real estate market was in balance. In short, the investment real estate market could absorb further closing of the gap between 10-year Treasury rates and market CAP rates, referred to as CAP rate compression, before investors should become alarmed that a correction in the commercial real estate market is on the horizon. With the U.S. economy and the rest of the world economy seemingly moving in opposite directions in the near future, it’s likely that the commercial real estate market will stay in a healthy market zone throughout 2015. Interest rates will likely stay stable through 2015, but beyond that, it’s anyone’s guess.
William Small is managing director of Zenith Realty Advisors LLC, a firm specializing in advising investors and owners of investment real estate. If you are interested in receiving his reports on real estate investing and trends, you can reach him at 970-925-3866 or firstname.lastname@example.org.
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