What should the expectation be for capitalization (cap) rates and commercial real estate asset pricing as the Fed continues to cut interest rates? The short answer is, all else equal, a reduction in interest rates should result in a compression of cap rates, thereby increasing commercial real estate prices. This is because lower interest rates result in higher net cash flows available to the investor after accounting for debt service.
This may be thought of as the spread between the cap rate and the interest rate. As interest rates fall, an investor who was willing to accept a 300-basis point spread between a 5% borrowing rate and 8% cap rate would theoretically accept the same 300-basis point spread on a 7% cap rate if their borrowing rate fell to 4%.
Keep in mind, cap rates and interest rates are not 100% correlated. However, buyer beware, interest rates are not the only variable affecting cap rates and the underlying asset pricing.
In addition to an individual investor’s own return requirements, which will vary based on their risk appetite, there are many other data points to analyze in a commercial real estate investment.
Other variables that should be considered are business terms of the lease, the makeup of the asset and the health of the overall market. The business terms of the lease include the duration of the lease, what is the base rental rate and how does it compare to market rents; who is responsible for various maintenance-related items of the leased asset and how creditworthy is the tenant.
The general makeup of the asset would include variables such as location, age, condition, and competition. Any of these variables that reduce the risk of the investment should also reduce the cap rate an investor is willing to pay and those that increase the risk should increase the cap rate.
Longer-term leases, well-located properties, newer assets, below-market rental rates, and better credit tenants would all represent less risk when compared to the median. On the contrary, short term, poorly located, obsolete or older assets, above market rents and low-credit or no-credit tenants would all represent variables having a higher degree of risk and thereby resulting in a higher cap rate expectation.
All of these variables contribute to the overall risk of any given investment opportunity and for each one that reduces one area of risk there may be another that increases a different area of risk, but all should be considered together.
As we move through the third quarter, with expectations growing for another rate cut in September, it will be interesting to see how much further cap rates may compress and if commercial real estate asset prices increase, understanding that interest rates are only one of the variables that determine asset pricing.
