The initial query: What’s the relationship between real estate cap rates and interest rates?
We have been travelling the country to speak with financial advisors about our views on the macro environment and current conditions for private markets asset classes.
A curious advisor considering an initial investment into private real estate asked about how cap rates are related to interest rates over time. Was there any kind of correlation between them? And how should he be thinking about this asset class as rates rise and/or remain structurally higher?
FAST takeaway #1: cap rates have a low correlation to interest rates.
We believe it is helpful to start with the long-term time-series. The chart below plots from 1985 to present.
Cap Rates vs. 10-Year Treasury1
Visually, cap rates show a long-term trend downward alongside rates. However, there are periods of time where cap rates and treasuries moved inversely to each other (~2001-2009, 2020-today). In total, the long run correlation between the two has been low at 0.1.
The follow up query: what about if we look at this on a lag?
The advisor was quite surprised to see such a low correlation, and suspected many of his clients and colleagues would not have suspected this. In fact, he challenged us to look at the same data with some lags to see if the outcome changes at all.
FAST takeaway #2: it doesn’t make a difference to lag; correlations remain low.
While applying a 24mo lag on cap rates visually looks like a bit better fit, with the peaks and troughs aligning to interest rates a bit better (see chart), correlations remain low (and even negative… see correlation table).
Lagged Cap Rates vs. 10-Year Treasury1
Here are the correlations with those lags1:
| Cap Rates 6mo Lag | Cap Rates 12mo Lag | Cap Rates 18mo Lag | Cap Rates 24mo Lag |
|---|---|---|---|
| -0.04 | -0.10 | 0.05 | 0.09 |
To summarize
The advisor’s takeaway and ours is that the relationship between cap rates and interest rates is much more complex and dynamic than many suspect. As we face an environment of rising / structurally higher rates, it is not a foregone conclusion that cap rates follow suit.
Interest rates are an important input into cap rates, particularly over the long-term…but not the only one. In the short run, other factors (such as NOI growth expectations, credit spreads, inflation regime, liquidity conditions, to name a few) also play a significant role and can drive divergences from simply rates themselves, resulting in a more nuanced opportunity than one might expect.
