Cap Rates resetting and the Fed

The Federal Reserve has indicated that there is potential for further increases in interest rates during 2022 and this has led to speculation that there would be widening of cap rates; however, the relationship between changes to the federal funds rate and cap rates is not direct and instantaneous as the relationship between the federal funds rate and interest rates is. The consensus of all those surveyed recently in a Newmark white paper is that cap rates are far more “sticky” than interest rates, and any market correction won’t be illustrated until the 2nd quarter of 2023 at the earliest.

The impacts to both the residential and commercial real estate markets have been material as borrowing costs have increased significantly. It is expected that “rescue equity” will be needed to replace the capital shortfalls as values decline and cost of debt rises. Further, negative leverage is occurring as mortgage rates trend above capitalization rates which is unsustainable.

Transactions have slowed, deals have stalled and there has been a lack of current data points which has reduced clarity with respect to price discovery and valuations. The majority of investors surveyed by PwC expect capitalization rates to increase over the next six months.

Cost of Capital

The increase in base interest rates directly affects financing rates. Various debt sources are quoting and achieving mortgage interest rates 6% and above. This is creating a situation where debt coverage ratios are too low based on existing cash flows and this, in turn, is forcing lower leverage and greater equity positions.

Capitalization Rates

In the 3Q2022 PwC Real Estate Investor Survey, it was noted that “The current rising-interest- rate environment has many investors in the commercial real estate (CRE) industry using the words selective, tentative, and cautious to describe their approach to acquisitions today.”

The majority of investors surveyed by PwC expect capitalization rates to increase over the next six months. This translates to slowing transaction volume but also directly impacts pricing expectations.

Green Street – Cap Rate Observer – October 2022
Property Type Sector	Current Cap 3 mo. ▲ Rate (bps)
Apartment	4.9% +55
Industrial	4.6% +25
Office	7.6% +85
Strip Center	6.5% +30
Self-Storage	4.8% +20
Single-Family Rental	4.9% +25
Compiled by Newmark

Investors expect, and the data is showing, that capitalization rates are increasing. We have also heard of specific transaction examples including repricing of deals and simply offers at lower levels owing to the increased cost of capital.

Property Values

The next question is whether these capitalization rate increases are translating to property value declines. We must continuously keep our ears to the ground and talking to investors and brokers which is a must in this environment.

Investors have become selective, cautious, and tentative as cost of capital has increased.
Volatility in the market has led to the disconnect between buyers and sellers thus reducing transaction volume – both in number of sales and overall price volume.
Although the number of transactions has dropped precipitously, market participants are saying that price discovery is demonstrating that values are trending lower.
Negative leverage is present in the market and this cannot be sustained which is putting downward pressure on values.
Brokers report re-trades are occurring at lower pricing and higher indicated capitalization rates.