As the Federal Reserve begins to cut interest rates, real estate investors are closely monitoring the effects on capitalization (cap) rates. This blog post will analyze CBRE’s research on the relationship between interest rates and cap rates and provide insights on what real estate investors can expect in the current market climate.
The Link Between Interest Rates and Cap Rates
The primary mechanism that influences real estate cap rates is the movement of Treasury yields, especially the 10-year Treasury bond. Cap rates—calculated as the ratio between a property’s net operating income (NOI) and its current market value—are essential for assessing property investments. When Treasury yields fall, the cost of capital decreases, leading to downward pressure on cap rates.
According to CBRE Econometric Advisors, their analysis of cap rates since 1995 shows that for every 100-basis-point change in the 10-year Treasury yield, cap rates adjust differently across property types:
- Industrial assets: 41 basis points (bps)
- Retail assets: 78 bps
- Office assets: 70 bps
- Multifamily assets: 75 bps
Industrial real estate is generally less sensitive to long-term interest rates due to strong demand for logistics spaces, which persisted through the COVID pandemic. In contrast, sectors like retail and office spaces have exhibited higher sensitivity to interest rate shifts.
Factors Influencing Cap Rates
Several macroeconomic conditions influence cap rates beyond just interest rates. CBRE’s study highlights key drivers such as:
- Liquidity and risk premium: The spread between cap rates and Treasury yields tends to widen during economic downturns and narrow during recoveries.
- Gross Domestic Product (GDP): Higher GDP growth can support rent growth and higher property valuations, leading to cap rate compression.
- Foreign Exchange Rates: A stronger dollar can attract foreign investments, influencing cap rate trends.
- Inflation: Rising inflation often raises the cost of capital and limits the potential for cap rate reductions.
- Fed’s Balance Sheet: The impact of market liquidity through quantitative easing can also drive investment demand.
How the Current Cycle is Different
While CBRE’s research historically shows a strong link between interest rates and cap rates, the current market is unique. The COVID pandemic created structural shifts, particularly in sectors like industrial real estate, where demand surged due to increased reliance on e-commerce.
The infographic above illustrates the forecast for cap rates across different sectors, showing that Treasury yields and GDP growth will significantly influence market conditions. According to CBRE’s data, we can expect:
- Industrial cap rates: Projected to fall by 40 bps by the end of 2025.
- Retail cap rates: Expected to compress by 35 bps.
- Multifamily cap rates: Forecasted to decrease by 25 bps.
- Office cap rates: Estimated to drop by only 20 bps, reflecting the challenges of the sector.
CBRE’s Economic Outlook
CBRE Econometric Advisors predict that the U.S. economy will avoid a recession as inflation trends toward the Fed’s 2% target. Their forecast suggests the 10-year Treasury yield will stabilize below 4% for the remainder of 2024 and into 2025. This soft-landing scenario supports resilient fundamentals for sectors like industrial and multifamily, where cap rates will continue to experience moderate compression.
In the long run, CBRE expects industrial and multifamily cap rates to stabilize around 4.5%, while office and retail cap rates will be higher than pre-pandemic levels, reaching approximately 5% and 4.6%, respectively.
Key Takeaways for Investors
Given the evolving market conditions, investors should closely monitor several factors when assessing future investment opportunities:
- Macroeconomic Drivers: Understand broader macro drivers beyond just Treasury yields. Keep an eye on the Fed’s balance sheet, inflation trends, and GDP growth as key influencers of cap rate movements.
- Sector-Specific Sensitivities: Different property sectors react differently to interest rate cuts. Industrial and multifamily assets remain resilient, while office and retail spaces may face challenges.
- Long-Term Strategy: Investors should consider the structural shifts in demand for assets like logistics and adapt their portfolios accordingly.
By analyzing both current cap rate trends and broader macroeconomic conditions, real estate investors can make more informed decisions during this interest rate cycle.
For more insights on how we at Ironsides Group analyze macroeconomic data to guide real estate investment strategies, check out our services or contact us to explore investment opportunities.