There is an economic concept known as “opportunity cost” which tries to explain the idea that there is a forgone benefit when one option is chosen over another. For example, if an individual decides to hide cash under their mattress, they can be assured that it will be safe, but they are forgoing the chance to earn interest on it when placed in a bank account. This same concept applies to commercial real estate investment.
When an investor chooses to invest in a commercial property, they are also choosing not to invest in another asset class, which may or may not have a higher return. This is the idea behind studying the cap rate spread – the difference between the interest rate on the 10-year treasury and the cap rate on a property – in commercial real estate.
In this article, we will further define what the cap rate spread is, how it is calculated, and why it matters in commercial real estate investment. By the end, readers will have the information needed to incorporate the cap rate spread into their investment due diligence process.
At First National Realty Partners, we pay close attention to the cap rate spread as part of a robust risk management program. In doing so, we are able to identify the deals that have the greatest chance for market beating returns. To learn more about our current investment opportunities, click here.
What is the Cap Rate?
In commercial real estate investing, a property’s capitalization rate – cap rate for short – is a performance metric that describes the relationship between the property’s net operating income (NOI) and current market value. When evaluating a potential real estate deal, the cap rate provides investors with two important pieces of information:
- First, it provides investors with an indication of the annual rate of return assuming the property is purchased with cash. Cap rates are impacted by a variety of factors including the potential growth rate, operating expenses, liquidity, and tenant leasing activity.
- Second, cap rate provides investors with an indication of the market’s assessment of the risk associated with the property. Higher cap rates suggest higher risk, meaning that investors must receive a higher return to compensate. Lower cap rates mean less risk, so investors are willing to accept a lower return.
For the purposes of this article, a property’s cap rate is a key input into the cap rate spread calculation.
What is the Cap Rate Spread?
The cap rate spread is a metric that attempts to quantify the risk in an investment. Cap rate spread is defined as the difference between the interest rate on the 10-Year Treasury and a property’s cap rate. The cap rate spread formula is quite simple (cap rate spread = interest rate on 10-Year Treasury – property’s cap rate), but what the cap rate spread represents is much more powerful.
When a real estate investor purchases a 10-year treasury, the investor is making a loan to the US government and expects to receive their money back – plus interest – when the term is up. A loan to the US government is considered to be as risk-free as an investment gets, which is why the interest rate on the 10-year treasury is often referred to as the “risk free rate.”
As described above, the cap rate represents the annual return on a CRE investment, assuming it was purchased with cash. Because commercial real estate assets come with more risk than a 10-year treasury, it stands to reason that an investor should earn a higher rate of return.
With this in mind, the cap rate spread can be further defined as the difference between the interest rate on the 10-year treasury and the prevailing cap rate for a property. The cap rate spread represents an investor’s compensation for purchasing a real estate asset and not a treasury. For example, if an investor purchases a property at a 6% cap rate when the interest rate on the 10 year treasury is 2%, the “spread” of 400 basis points (4%) represents their compensation for the additional risk of purchasing an investment property over the bond.
Why Does The Cap Rate Spread Matter in Commercial Real Estate Investment?
10-year treasury yields are not static. They move every day and cap rates tend to move with them. But, it isn’t a perfect correlation. The spread between 10-year treasury yields and cap raters can expand and contract based on macroeconomic conditions. In times of economic uncertainty, real estate investors tend to prefer the relative safety of treasuries, so the cap rate spread expands. In times of economic growth, investors feel more comfortable with risk so they tend to sell treasuries, which drives rates up and compresses the cap rate spread. The following chart illustrates this point:
Source: NAREIT
The above chart shows the 10-year treasury rate versus average cap rates for various commercial real estate property types. From 2007 – 2010 – the financial crisis – it can be seen that 10-year treasury rates declined while CRE cap rates rose causing the spread to increase. In addition, it shows the spread for various property types. For example, multifamily tends to be more stable so the cap rate spread is lower. At the other end of the spectrum, office buildings and hotels tend to come with higher risk so the spread is bigger.
Post-2010, as the economic recovery takes shape, treasury yields stay relatively stable while property cap rates come down significantly – causing asset values to rise – which narrows the spread.
The bottom line is this, the cap rate spread in commercial real estate matters because it provides investors with information about the future direction of property prices and risk. When the cap rate spread is wide, it suggests a riskier investment environment, which is why the compensation over treasuries must be higher. When the spread is low, it suggests that the economic market conditions are much more stable, so investors are willing to accept a lower return for the incremental risk over treasuries.
Summary and Conclusion
- The cap rate spread is the difference between the interest rate on the 10-year treasury and the cap rate on a property. It represents the incremental risk/return between purchasing a treasury and a real estate asset.
- In commercial real estate investment, the cap rate spread matters because it provides real estate investors with information about the broader economic environment. In general, the cap rate spread is high in times of economic distress and lower in times of economic growth.
- This information should be used in the underwriting process to help gauge the proper purchase price in a commercial real estate investment transaction.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
