Cap Rate to 10-year Treasury Spreads

A recent post titled “CRE Cap Rates vs. 10 Year Treasury” over at Marketwi.se reminded us of a Cornerstone Advisers research report titled “Cap Rates and Real Estate Cycles“.

In this report, Cornerstone published a graph which tracked NCREIF Cap Rates v.s 10-Year T-Bill yields since 1983. The NCREIF may be a bit more comparable benchmark to the 10-year T-Bill, as it is more institutional in nature.

It is easy to notice the sharp fall in cap rates beginning in 2002, and the resulting spread compression experienced up until mid-2007. But this is not the most striking illustration in the report. Next, they add Corporate Baa bond yields to the same graph. Not since the early 1990′s were average cap rates lower than Corporate Baa debt yields.

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Unlike an investment in a corporate Baa bond, where the primary investment risk is a change in the company’s credit rating, there are additional risks associated with real estate ownership. These additional risks include investment illiquidity and exposure to capital calls to pay real estate taxes and other carrying costs if there are operating cash shortfalls. For these reasons, most sophisticated investors are quick to acknowledge the additional risk premium required for successful real estate investing. But by 2005 or so, the average NCREIF cap rate was lower than Corporate Baa debt yields.

The Cornerstone report sums it up well:

The relationship between real estate cap rates and corporate bond yields inverted in 2005; which possibly suggests real estate pricing became too aggressive. Corporate bond yields spiked as the grip of the credit crisis took hold, while adjustment in cap rates initially lagged behind [...]

Easy access to low cost debt may have helped fuel a surge in real estate equity investment activity that took property investment markets into unsustainable territory.

Abundant liquidity in the debt markets indirectly fueled pricing competition in investment sales with investors underestimating risk and/or overestimating growth in property income and appreciation.

We are regular readers of Marketwi.se, as they consistently have relevant, thought provoking posts. Keep with the great work, John and Chris!