Why Do Real Interest Rates Matter For Real Estate?
First and foremost, there is a very close statistical relationship between real interest rates and cap rates or yields1 (Figure 1 shows this for the U.S.). The long downward trend in cap rates dates from the mid-1990s and is not just a product of QE and the post-GFC world, but is also heavily linked to the fall in real interest rates.
FIGURE 1: U.S. | CAP RATES AND INTEREST RATES
Source: CBRE/Macrobond, NCREIF, August 2018.
Secondly, cap rates (or yields) are closer in economic terms to real interest rates than to nominal ones. To understand this, consider the following three points:
- Property A has a value of $2,000 with net operating income (NOI) of $100 in year one and a cap rate of 5%.
- If inflation is 2% and the NOI of Property A keeps up with inflation, then the NOI of Property A will be $102 a year later.
- With a cap rate of 5%, the property is priced at $2,040.
Viewed another way, the owner of Property A has achieved a 5% return over and above inflation. In other words, the cap rate is a real rate of interest, and therefore directly related to the rate of interest provided by banks less expected inflation. Real estate typically provides a higher real rate of interest than do banks because of the risks and costs associated with owning real estate. This spread of cap rates has some cyclicality, but is relatively constant in the long term, reflecting the stable nature of real estate as factor of production.
Since 1990, inflation has been low and stable, so the difference between real and nominal interest rates also has been relatively low and stable. Cap rates move quite closely with both variables. However, economically and statistically, it is real interest rates that drive cap rates.
FIGURE 2: U.K. | PROPERTY YIELDS AND REAL ESTATE INTEREST RATES
Source: CBRE/Macrobond, MSCI/IPD, August 2018.
In the U.K., the historic relationship between cap rates/yields and real long-term interest rates is complicated by the monetary turbulence of the 1970s, and the cyclical pattern in yields1 is very pronounced (particularly during the recessions of the mid-1970s, the early 1990s and the GFC of 2008). Nonetheless, the long-term relationship between yields and real interest rates shows through clearly and there is statistical evidence of a 1-for-1 relationship in the long run, albeit with a lag.
Japanese all-property cap rates fell by 210 basis points (bps) between late 2002 (when the data begins) and late 2017. This was the same as the fall in real long-term interest rates and considerably more than the 100-bp fall in nominal rates. Even in Germany, where yields have been extremely stable in the past, there is statistical evidence of a 1-for-1 relationship with real long-term interest rates, again with a (quite lengthy) lag.
Figures 1 and 2 show that there are other factors that influence cap rates, even if they follow real interest rates in the long term. Sometimes there is a large cap rate spread over real interest rates; sometimes there is a lower spread. Usually, this spread is related to expectations about rent growth, which, in turn, are related to supply-and-demand conditions. If demand for real estate is high relative to availability, cap rates tend to fall. Where availability is high, perhaps due to a wave of new completions, cap rates tend to rise. Cap rates can also reflect the availability of debt and other types of liquidity, which sometimes varies with the cycle and at other times with central-bank guidance. Broadly, investors should consider this formula:
CAP RATE = REAL INTEREST RATE + SPREAD
Spread = f (expected rent growth, debt availability, performance of other assets)
Real long-term interest rates are the key driver of cap rates. In effect, cap rates move 1-for-1 with real interest rates in the long run.
1 We refer to cap rates in the U.S. and to yields elsewhere, although they are essentially the same thing. We have used the term cap rates when making generic arguments.
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