Fed rates and cap rates. What’s really going on and how well do they correlate?
So feds are projected to increase rates (let’s say 75 bps in 2022). Knee jerk reaction seems to be increase residual cap rates by 25-50 bps depending on hold period. I am trying to make a correlation between cap rates and fund rates. When I look at 2015 through 2018 when fund rates increased over 200bps, there seemed to be no impact to cap rates at all. Just curious what others are doing to justify cap rate expansion when history doesn’t necessarily seem to show a strong correlation with increases in fund rates.
[{"id": "hsbrith", "text": "Off topic but I think they are raising rates higher than 75 bps. \n\nIf they don\u2019t inflation is gonna continue to go wild and cap rates will remain low. Inventory will remain low as well.", "replies": [], "depth": 1}, {"id": "hsc28au", "text": "Depends on demand more than any other thing.\n\nCap rates on industrial will remain similar to today, perhaps even improve for owners. Office, it will depend on the market. Residential will be impacted more by increases in fed rates than any other product.", "replies": [{"id": "hsc6ulp", "text": "Curious as to why you think residential will be impacted and not industrial? Both have similar levels of demand currently.", "replies": [{"id": "hsc9a2o", "text": "Because individuals (and bankers) panic.\n\nInstitutions less so.\n\nAnd for the next 50 years, industrial will be king.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "hsdc20o", "text": "Feds = FBI\n\nThe Fed = The Federal Reserve", "replies": [{"id": "hsejed3", "text": "Haha, good catch.", "replies": [], "depth": 2}], "depth": 1}, {"id": "hsdxzxb", "text": "There's a decent amount of research on this that suggests while fed funds rates and cap rates are correlated, the relationship is pretty weak.  Here's a helpful paper from [Nuveen](https://www.tiaa.org/public/pdf/thre_thinkus_rising_interest_rates.pdf) and one from [Principal](https://www.principalglobal.com/documentdownload/142008).   \n\nKnowing that, I don't think it makes much sense to say that just because rates will increase, cap rates will too.  \n\nFor example, I work at a CRE PE shop and we target institutional multifamily development. We have a few properties under construction that will start lease-up in the spring. Currently, I'd guess if they were fully occupied and on the market, we could probably sell them around a 4.25% cap rate on FY1 NOI projections.  Maybe lower.  \n\nLet's say the feds raise rates by 100bps before year end.\n\nKnowing nothing else other than fed funds rates are up, I think this time next year, if we were fully occupied, I'd still guess we could still sell them around a 4.25% cap rate on FY1 projections. Maybe lower.\n\nWhy?  From May 2004 to Sep 2007 the fed funds rate moved from 1.0% to 5.25%.  What did cap rates do over that 2.5 year time frame?\n\nCheck out the cap rate data in those two papers cited above and this chart here from [Berkadia](https://base.berkadia.com/blog/retrospective-look-historic-cycle-commercial-real-estate/).  \n\nThey fell 50bps from 7.0% to 6.5%!\n\nThat's of course only an example (of course there are times when rates rise and cap rates rise), but I do think it shows that one metric isn't going to determine price.  \n\nFor example, with multifamily and industrial, if all else is equal this time next year as it is today (high tenant demand, high investor demand, limited new supply relative to demand, high NOI growth), and the only change is the fed funds rate, I still think cap rates will be where they are today. Similarly, with office, interest rates might rise, but if COVID goes away and people finally return back to the office, cap rates might fall.\n\nAfter the GFC, in July 2011, I bought $500 of a triple levered inverse treasury bond ETF because my boss told me he'd never seen t-bill rates (sub-3%), and they'd have to rise soon.  Seemed reasonably enough.  They didn't cross 3% again until Dec 2013, and they were above 3% four times over an eight-day span.\n\nDidn't cross 3% again until the summer of 2018.  ETF went bankrupt and I lost all my money long before then.\n\nI say all that because if anyone is telling you that an interest rate (or really any valuation metric) can't go lower *only* because they've never seen it before, don't believe them.", "replies": [{"id": "hseg9fi", "text": "Thanks for your thoughtful response. I\u2019ll need to dig into your links, but what  I\u2019ve found so far is that there is a much higher correlation between 10 year treasuries and cap rates. Then I try to tie the fed fund rate to 10 year treasuries which is less correlated. In summary, I think my though process is flawed by assuming cap rates are strongly correlated with 10 year treasuries which are lesser correlated to fed funds rate so there must be a correlation between caps and fed fund rates. I think you\u2019re right that MF and industrial caps will stay the same or maybe even decline just because there seems to be a tidal wave of capital and they\u2019ll likely all be chasing the same deals.", "replies": [], "depth": 2}, {"id": "hservsj", "text": "You\u2019re selling multi at a 4.25%!?! What markets? Everything in SE has a 3 handle right now.", "replies": [{"id": "hsftemg", "text": "They are selling brand new fully occupied at 4.25% in that scenario. Stuff selling at a 3 handle in the southeast is value add. Its a 3 handle because Im reasonably certain NOI will be much higher once I take over and run my business plan so the cap on proforma  is much wider. Even still I model selling at a 4.5-5 cap in 4 years", "replies": [], "depth": 3}, {"id": "hsivlaq", "text": "Also in the south.  It just depends on how you calculate/project the numerator.\n\nThe broker's book could show that they project FY1 NOI at $3.4M and if you sell it for $80M, then its at a 4.25% cap.\n\nIf your proforma shows FY1 NOI at $3M, and someone buys it for $80M, then it's a 3.75% cap.\n\nIn both instances, you sold it for $80M, but your cap rate is different because both you and the broker are using a different projection for what you think it could earn. In today's environment, some people are thinking rents are going to grow by 20% y-o-y again, so FY1 NOI numbers are nuts.  Some think its still going to grow at a crazy rate, just not 20%.  One of them will be right.\n\nSo (I think) it's kind of a fools errand to figure out what the \"right\" cap rate is (ie - what cap rate you sold it for) on a property that isn't economically stabilized yet.\n\nYou're using educated guesses and hoping you're correct.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}]