The Cap Rate Spread’s Underlying Message
If history is any indicator, this is no time to sit on the sidelines, observes Parkview Financial's Himanshu Tiwari.
Last month, the Federal Reserve raised interest rates for the ninth consecutive time in its ongoing attempt to stop inflation. The rate is now at 5 percent and pundits are divided as to where rates are going in the future. Because of the market uncertainty, many investors are afraid of transacting. However, this is a mistake. The savvy investor, armed with a knowledge of history and understanding of cap rates, can make outsized returns while the competition is waiting on the sidelines.
According to CBRE, multifamily cap rates increased over 100 bps between April 2022 and December 2022. The Fed funds rate has increased substantially during this time, which has pushed 10-year Treasury yields (market indicator of risk-free interest rates) higher by over 450 bps as well. Whenever there is a shock to the market, reported cap rates lag the reality on the street by several quarters. In order to make prudent decisions, the savvy investor should instead be looking at the spread between reported cap rates and the 10-year Treasury yield (cap rate spread). This is an estimate of the risk premium involved with multifamily investments and also an early indicator of future cap rate movements. Below is a chart of the 10-year Treasury yield, multifamily cap rates and the cap rate spread over last two decades.
The current cap rate spreads are most similar to the historic period of the 1980s. During the Volcker years, the Fed increased rates aggressively, pushing 10-year Treasury yields higher. During this time period, the cap rate spread averaged negative 2.8 percent, according to Crow Holdings. While it is counter intuitive to those used to the low interest rate environment of today, multifamily properties on an average appreciated 5.7 percent year-over-year during this time period. This is much higher than the 4.2 percent average over the last 100 years. Investors that wanted certainty in the market lost out on high appreciation.
In the past, whenever the Fed changed its stance to reducing interest rates, the spreads have witnessed an instantaneous expansion (2006, 2011, and 2018 in the graph). In all these times, the expansion has preceded a reduction in market cap rates and is the lead indicator of changing times.
With the expectations of a Fed pivot in next few quarters, the cap rate spread may start to widen. When it widens, it will be almost instant, leaving no time for investors to re-strategize. The ideal time to acquire a property is right now. The savvy investor will be well positioned to take advantage of the situation and able to sell when cap rates eventually constrict again. Instead of waiting and observing, seize the opportunity and make that long-awaited real estate deal.
Himanshu Tiwari is an underwriter at Parkview Financial.