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CRE Finance World, Summer 2013

of less risky investments into higher risk investments and the Fed raises interest rates to keep the economy from overheating. Conversely, interest rates tend to fall as the economy contracts with investors doing the reverse, selling out of risky assets and into lower-risk assets while the Fed cuts interest rates to stimulate a sputtering economy. Interest rates are counter-cyclical. However, commercial real estate fundamentals and investor sentiment are generally pro-cyclical, meaning that fundamentals improve and investor sentiment escalates when the economy is recovering,while both deteriorate when the economy is worsening. Because an improvement in fundamentals translates into greater net operating incomes for buildings in the future (controlling for lease rollover), all else being equal this should generate an increase in the value of the buildings as the discounted income becomes greater. Moreover, as the economy improves and investor sentiment increases, investors bid up the value of commercial real estate, partially in response to improving fundamentals but also because the risk associated with owning commercial real estate assets decreases as the economy improves. As risk premiums compress, discount rates fall and building valuations increase. Empirical Tug of War This leads to a tug of war between the effects originating in the broader capital markets, namely interest rates, and the effects originating in the real estate markets, namely the changes in fundamentals and risk appetite. On a national basis, the result of this tug of war is slightly counterintuitive. When we examine cap rate data over the last 10 years, chosen due to the real estate market maturation and higher quality and availability of cap rate data, we can see that cap rates and interest rates actually do not correlate very well. For this examination we are using cap rates in the office sector because it is thought of as the bellwether sector for commercial real estate. We use the 10-year Treasury rate as our proxy for “interest rates” because of the typically longer holding periods for commercial real estate. Empirically, we generally observe a negative correlation between interest rates and cap rates. Prior to the recession, from mid 2003 to mid 2006, interest rates were generally rising while cap rates CRE Finance World Summer 2013 36 were generally falling. Although rising interest rates put downward pressure on valuations, improving fundamentals and investor sentiment exerted a greater effect on valuations. With values rising faster than net operating incomes were increasing, cap rates fell. The correlation between the national office cap rate and the ten-year Treasury rate during this period was roughly -.64, indicating that they were moving in opposite directions. Moreover, because correlation is bounded between -1 and +1, -.64 indicates a strong negative relationship. Figure 3 10 Year Treasury Rate vs. National Office Cap Rate Source: Reis, Inc., Federal Reserve Beginning in mid 2006 and lasting until early 2009, the reverse was true – interest rates plummeted downwards as the Fed tried to stave off the recession and investors fled riskier assets. Valuations plummeted faster than NOIs even though the declines in interest rates were putting upward pressure on real estate valuations, and consequently cap rates expanded dramatically as sentiment turned against real estate. The correlation between the national office cap rate and the ten-year Treasury rate over this interval was roughly -.59, indicating that they were once again moving in opposite directions and once again we have a strong negative relationship. Interest Rates, Cap Rates and Commercial Real Estate Values


CRE Finance World, Summer 2013
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