With interest rates steadily climbing, we’ll likely see the commercial real estate investment markets cool off, along with more parity between office space opportunities (the sector has struggled of late) and industrial space investment activity (which has been hot for several years).
However, interest rates shouldn’t be the only factor in a CRE investment decision, of course. Location and industry-specific trends (e.g., the life sciences boom in the Denver-Boulder corridor) also help determine demand, supply, and therefore the market price of a property.
The Cap Rate Spread
Another key data point that can help inform CRE investors regarding new opportunities is the cap rate spread for a property.
The cap rate spread is the difference between interest rates (usually pegged at the rate for a 10-year Treasury Bond) and the cap rate for the property (the ratio of annual income produced by that property to its purchase price).
Looking at the Cap Rate Spread Math
Let’s say, for example, that:
- The 10-Year Treasury Bond is 3.0%.
- The cap rate for an industrial property in Commerce City is 5.9% and the cap rate for an office property in Aurora is 7.1%.
In this example, the cap rate spread on the industrial building is 2.9, while it’s 4.1 for the office property. But what does that mean?
“In general, a higher cap rate spread represents a stronger investment with the likelihood of a significantly better risk-adjusted return compared to an investment, for example, in a safer (but lower yielding) government bond,” explains Justin Rayburn, Principal and Co-Owner at Fountainhead Commercial. “It’s more likely to be worth the risk to invest in CRE when compared to other assets.”
Conversely, a low cap rate spread indicates the risk-adjusted return from that CRE property isn’t likely to outperform the “risk-free” government bond rate by a very wide margin.
A Perspective on Today’s Cap Rate Spread
According to a recent Colliers review of Federal Reserve data, the current nationwide industrial CRE cap rate spreads are significantly lower than the historical average – by 70 basis points (28%). In contrast, current office CRE cap rate spreads are basically in line with historical averages (just 4% lower). Similarly, current retail property investment cap rate spreads are essentially the same as their nationwide historical average – a mere 4.4% higher.
The data also indicates the current difference in cap rate spreads is driven by property type. Industrial, office, and retail cap rate spreads historically have been nearly equal: 2.50, 2.40, and 2.30, respectively. Now they stand at 1.80, 2.30, and 2.40, respectively. All other things being equal, this indicates that industrial CRE investments are trading at a risk-adjusted premium versus office and retail building investments at this time.
(Note: This analysis used the BBB bond rate rather than the Treasury 10-year bond rate in determining cap rate spreads. Since BBB bonds represent marginally more risk, and thus offer a higher rate, the reported cap rate spreads here are narrower than if the Treasury 10-year bond rate had been used.)
The Takeaway for CRE investors
The recent extended period of low interest rates and availability of investment capital has contributed to high valuations in 2021 and YTD 2022. But as interest rates go up, investors’ buying power will decline.
“Thanks to the Fed’s interest rate ratcheting up, with two more interest rate increases expected before end of 4Q 2022, cap rate spreads for all CRE can be expected to narrow and investors who are still operating in accordance with recent CRE trends may end up paying a premium for certain categories of property,” cautions Lowrey Burnett, Principal & Founder at Fountainhead Commercial.
Instead, CRE investors that don’t need to deploy capital immediately might be wise to sit on the sidelines and “keep their powder dry” until sellers adjust pricing downward in response to higher interest rates and the potential of less investor demand.
At some point, this will lead to price stability, which will support higher cap rates (i.e., higher yields) and increased cap rate spreads. CRE investors should be prepared to jump back into the market at that point.
We’re watching this situation closely. If you’re contemplating the purchase of one or more CRE investments, please contact us and we’d be happy to identify the best opportunities that align with your overall investment strategy.
