The commercial real estate industry has evolved tremendously over the past thirty years: development has shifted between cities and suburbs, retailer footprints have ballooned only to contract again, and a wave of new technologies have revolutionized how people live, work and shop. Amidst all of these changes, the cycle of cap rate fluctuation in relation to interest rates has been a reliable constant.
The past nine years of low interest rates have defied expectations, and financial engineering on transactions has produced positive levered returns. This has heralded an unprecedented compression in cap rates, to levels that have, in many cases, surpassed the 2007 pre-recession benchmarks.
It seems inevitable that a rise in interest rates and a corresponding market correction is on the horizon. None of this is particularly earth shattering news, but the potential market impact is very much a part of our client conversations heading into 2017.
Historically, when interest rates rise, cap rates tend to follow. Yet, as the graph above demonstrates, there isn’t always a direct and proportionate correlation. The size of the spread fluctuates based on factors such as supply and demand, and credit availability, to more abstract and anecdotal influences. And it typically takes months for an interest rate change to have a noticeable impact on average cap rates – and oftentimes longer than that.
However, at the transaction level, the effects can be swift. When rates go up, some buyers pause, waiting to see whether things will get worse, or better. This creates stress on the transaction, as pricing and contingency deadlines (not construed for interest rate uncertainty) lead to the dreaded re-trade; or the deal simply falls apart. Conversely, other buyers may decide to “lock in” before things get any worse (the pressure of a 1031 exchange can also play a role in that decision).
Ultimately, sellers are left in a difficult position as record breaking prices become benchmarks of the bygone market. As brokers, we need to focus even harder during this phase of the cycle to uniquely position each asset and fine tune valuations, so sellers don’t get left behind by a moving target.
Notwithstanding the forgoing, we still see numerous reasons for seller optimism on the horizon: macroeconomic trends bode well for the future, the Fed appears committed to a cautious approach to raising rates, and a pro-business, real estate developer will soon occupy the Oval Office.
The commercial real estate market is a supertanker, and it doesn’t turn on a dime. But as we make our way into the new year and the new territory it embodies, we’ll keep a close eye on a variety of market inputs. Paramount among those is interest rates, particularly the 10-year Treasury, which, based on historical trends, will exert maximum influence on pricing and market velocity. So regardless of which side of the negotiating table you find yourself on in 2017, it will be wise to prepare, and stay a step ahead of these inevitable shifts.