Slowing Asset Price Growth to Push Cap Rates Higher, According to First American Potential Capitalization Rate Model

First American Financial Corporation, a premier provider of title, settlement and risk solutions for real estate transactions and the leader in the digital transformation of its industry, today released First American’s proprietary Potential Capitalization Rate (PCR) Model for the first quarter of 2022. The PCR Model estimates capitalization rates based on the historical relationship between interest rates, rental income, prevailing occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends.

Commercial Real Estate Economist Analysis: Cap Rates Remain Near All-Time Lows in First Quarter 2022

“When inflation first began to surge in 2021, many believed it would be transitory. Inflation has remained stubbornly high, however, prompting the Federal Reserve to tighten monetary policy. In response, the yield on the 10-year Treasury note has more than doubled, from 1.5 percent at the end of last year to nearly 3.5 percent in mid-June,” said Xander Snyder, senior commercial real estate economist at First American. “The Fed’s increases to the federal funds rate,which began in May this year, indirectly impact longer-term yields, such as the 10-year Treasury note. However, quantitative tightening, the Fed’s other tool to tighten monetary policy, will directly impact the 10-year Treasury bond. The Fed began quantitative tightening in June and is expected to continue quantitative tightening in the months ahead, so the yield on the 10-year Treasury is therefore expected to increase further.

“Investors often view the interest rate paid on a 10-year Treasury note as ‘risk free,’ so when considering investments with greater risk they typically seek a return greater than the 10-year Treasury yield,” said Snyder. “Since capitalization (cap) rates are a measure of return on an asset, higher ‘risk-free’ rates mean sellers will need to reduce their price expectations or increase cash flow, if that’s an option, to entice buyers seeking competitive yields, which should also push cap rates up.

“So far, this hasn’t happened. Cap rates remain near all-time lows and commercial real estate (CRE) price growth in the first quarter remained relatively robust, although slower than the record growth seen in the fourth quarter of last year,” said Snyder. “However, we know that interest rates have increased dramatically in the second quarter and are likely to continue rising, given the Fed’s efforts to fight inflation. So, how will rising interest rates impact cap rates throughout the rest of the year?”

Slowing CRE Price Growth Likely to Push Cap Rates Up

“First American’s PCR Model suggests that, while interest rates influence cap rates, recent CRE property price growth is a more significant driver,” said Snyder. “For example, in the first quarter of 2022, interest rates put upward pressure on the potential cap rate, but the downward pressure from record price growth in the previous quarter was much greater, so the potential cap rate declined to 4.3 percent, approximately 1 percent below the actual national cap rate of 5.3 percent.

“In the first quarter, however, national CRE price growth slowed on a quarter-over-quarter basis and is expected to push potential cap rates up. According to the PCR Model, the moderation in quarterly price growth in the first quarter will lead to a modest increase in the potential cap rate in the second quarter, which suggests actual cap rates will follow,” said Snyder. “As shown in this chart, higher interest rates contributed to an increase in the potential cap rate, but upward pressure from slower CRE price growth will be a much more significant contributor to the increase in the second quarter potential cap rate.”

A Return to Normal

“It’s worth noting that decelerating CRE price growth was not distributed evenly across asset classes,” said Snyder. “Multifamily and industrial assets set first-quarter price growth records, increasing at a faster rate than any other first quarter in the past 20 years, while office and retail assets were a drag on overall CRE price growth in the first quarter. However, a record amount of industrial square footage is currently under construction and expected to come to market later this year, which may slow price growth for industrial assets and put further upward pressure on the potential cap rate as the year progresses.

“Interest rates are higher today than they were a year ago and are now near mid-2018 levels. Yet, despite a comparable interest rate environment in 2018, commercial transaction volume increased by nearly 16 percent from the first quarter to the fourth quarter of that year. In other words, demand to own commercial property grew throughout 2018, even in the midst of a similarly challenging interest rate environment. Looking ahead, cap rates do appear poised to move upwards as investors shift their risk tolerance. However, more moderate CRE price growth reflects a shift to a new normal, rather than significant industry disruption.”

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