Like any investment, commercial real estate returns are driven by perceived risk. The more risk that a property has, the higher the potential return. The less risk, the lower (but more stable) the return. But, the tricky thing about risk is that it exists in both an absolute and relative sense. This means that each property has its own unique risks, but it also means that these risks are measured relative to the risk found in other investment options.
For investors, one common investment option risk comparison is 10-year U.S. Treasury Bill vs. a commercial property. The reason this comparison is important is because the 10-year US Treasury represents an investment with virtually no risk and a commercial property represents an investment with some risk. So, the potential returns are often measured relative to each other to ensure CRE investors are adequately compensated for the risk taken.
The intent of this article is to illustrate how changes in the interest rate on the 10-year Treasury impact commercial real estate prices. This discussion begins with a definition of the “Risk Free” rate.
What is the Risk Free Rate?
The “risk free rate” is the interest rate paid on a 10-year Treasury Bill. It is referred to as the “risk free rate” because repayment of a 10-year Treasury debt obligation is backed by the full faith and credit of the United States government. In other words, it is considered to have as little risk as an investment can have. The chart below shows that 10-year Treasury rates have ranged from ~.050% – 3.25% between 2016 and 2021.
So, if an investor can earn the rate paid on a 10-year Treasury, which is “risk free”, it follows that they should be compensated with a higher return for any investment that has more risk than a 10-year Treasury. This is where a commercial property’s capitalization rate or “cap rate” comes into play.
What is the Cap Rate?
In the context of this article, a commercial property cap rate serves two useful purposes.
First, it is a measure of the expected return that would be achieved assuming an all cash purchase of the commercial property. While the interest payments for a 10-year treasury are fixed, their CRE equivalent, net operating income (NOI), is variable and tends to grow over time. This means that there is a distinct relationship between a property’s cap rate and the amount and stability of the property’s cash flow.
Second, the cap rate can also be used as a barometer of the market’s perceived risk in an asset. In general, the safer the property, the lower the cap rate. The more risk associated with a property, the higher the cap rate. Cap rates are driven by a number of factors including: property type, property market, tenants, current occupancy, property condition, and the risk free rate.
What is the Relationship Between the Risk Free Rate and Cap Rates?
If the risk free rate is the return that an investor can achieve for taking no risk and the cap rate is the expected annual return for taking some amount of risk, it follows that these rates – and their movements – will be correlated.
The difference between the risk free rate and a property’s cap rate is the “risk premium” and it represents the incremental return that an investor can achieve for the risk of investing in a real estate asset. When the risk free rate changes, it is common for real estate cap rates to also change.
For example, suppose that the risk free rate is 2.50% and the market cap rates for a commercial shopping center are trading in the range of 6.50%. As a result the risk premium is 4%. Now suppose that the rate on the 10-year treasury bond rises to 3.00%. To maintain that same 4% risk premium, shopping center cap rates would have to rise to 7.00%, which means lower prices.
Aside from impacting property prices, there are additional insights that can be gained from studying the risk premium between treasuries and cap rates. For example, in the last major recession (the financial crisis), the spread between treasuries and cap rates declined to just .29% in the 2nd quarter of 2007, indicating potentially inflated real estate prices. As the market began to turn, investors began to demand higher returns and the spread increased to 4.42% by the second quarter of 2010. The increasing spread drove cap rates higher and real estate valuations lower.
By studying this spread over time, investors can possibly gain insight into the future of real estate prices. The smaller the spread, the more prices may be potentially inflated. The larger the spread, the more room there may be for cap rates to decline and prices to rise. NCREIF, a commercial real estate investing data provider, publishes an index of cap rates that can be used to complete this analysis.
Summary & Conclusion
The risk free rate is the interest that can be earned on a 10-year treasury bond. It is called the risk free rate because the bonds are backed by the United States government and full repayment is near certain.
The cap rate in a commercial real estate investment is a metric that indicates the rate of return that real estate investors could expect if the property is purchased with cash. They are the primary driver of commercial property values.
The difference between treasury yields and the cap rate is the “risk premium” that is demanded by investors for taking the incremental risk of purchasing a real estate asset versus a Treasury Bill.
As the treasury bond yields move, cap rents and real estate pricing tend to move in tandem. Studying the risk premium relative to historical trends can provide investors with an important data point about the future of commercial real estate prices and total returns.
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