TIAA-CREF Asset Management
Documeent title on one or two
Cap rates rising:
lines in Gustan Book 24pt
Fear and loathing in real estate
Martha Peyton, Ph.D.
Managing Director
Edward F. Pierzak, Ph.D.
Managing Director
U.S. interest rates are astoundingly low and have been for quite a long time.
But, it can’t last forever and investors are worried. Their fears are rooted in the
perception that rising interest rates will cause capitalization (cap) rates to rise
and thereby weaken property values and commercial real estate investment
performance. While seemingly a matter of straightforward arithmetic, we
believe these worries are overblown because they ignore variables that have
the potential to offset value declines. In fact, there are a number of factors that
may provide “protection” to overall property performance in a rising interest
rate environment. This paper examines the relationship between interest and
cap rates and the overlooked factors that should soothe investor fears. While
there is no guarantee that everything will turn out alright in the end, our short
scenario analysis shows that catastrophe is unlikely.
Up, up, and away?
The potential for rising interest rates has provoked considerable discussion among
real estate professionals. Specifically, investors worry about the impact of rising
interest rates on property cap rates and valuations. These fears tend to focus on
the arithmetic showing that rising interest rates result in increasing cap rates and,
all else equal, declining property values.
Exhibit 1 focuses on the relationship between interest rates and cap rates, with a display
of NCREIF Property Index (NPI) transaction cap rates and US 10-year Treasury yields using
data for the past 20 years. A rough positive relationship is evident between the two variables
as demonstrated by the black line imposed on the scatter.
Exhibit 1
NPI transaction cap rate and U.S. 10-year Treasury yields (1Q93 to 4Q12)
12
11
NPI cap rate (%)
TIAA-CREF
Global Real Estate
Strategy & Research
10
9
8
7
6
5
4
0
2
4
6
10-year Treasury yield (%)
Source: Moody’s Analytics; NCREIF, as of 4th Quarter 2012; TIAA-CREF
8
10
Cap rates rising: Fear and loathing in real estate
But, that rough relationship does not mean that cap rates
change in lock step with Treasury yields. The correlation
between the two variables is not a perfect 1.0, but rather
a moderate 0.6. More importantly, historical data show
that changes in Treasury yields do not necessarily result
in changes in cap rates. Our analysis finds no statistically
significant effect of Treasury rate changes on cap rates. 1
These findings confirm that cap rates are influenced by
a wider network of variables beyond interest rates. They
include real estate fundamentals, capital flows, and investor
risk appetite. 2
Spreads matter
In practical terms, the difference, or spread, between cap
rates and 10-year Treasury yields is typically sizable and has
the potential to act as a buffer that can absorb increases in
the 10-year Treasury yield without corresponding increases
in the cap rate. Exhibit 2 displays spreads between NPI
transaction cap rates and 10-year Treasury yields from
1Q93 to 4Q12. 3
NPI transaction cap rate spreads (1Q93 to 4Q12)
W
6%
Cap rate spread W
20-year average
5
4
3
2
1
1Q12
1Q11
1Q10
1Q09
1Q08
1Q07
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
0
1Q94
Exhibit 3
Consensus expectations (%)
Average Average
2015- 20202013 2014 2015 2016 2017 2018 2019
2019 2024
Real
GDP
2.1
2.7
3.1
2.9
2.8
2.7
2.6
2.8
2.5
Unemployment
rate
7.7
7.2
6.7
6.3
6.0
5.7
5.6
6.1
5.6
10-Year
Treasury yield
2.1
2.7
3.4
4.1
4.5
4.7
4.7
4.3
4.7
Consumer
Price Index
1.9
2.1
2.3
2.4
2.4
2.4
2.4
2.4
2.3
Source: Blue Chip Economic Indicators®, March 10, 2013 and
April 10, 2013
Exhibit 2
1Q93
In today’s environment, the most important factor that is
overlooked is that interest rate increases are anticipated
to coincide with strengthening economic and employment
conditions. Consensus expectations from the Blue Chip
Economic Indicators® shown in Exhibit 3 confirm this.
Source: NCREIF, as of 4th Quarter 2012; TIAA-CREF
The current cap rate spread is over 500 basis points; the
20-year historical average is slightly more than 300 basis
points. That extra spread can absorb an increase in 10-year
Treasury yields and/or a further reduction in cap rates before
property values are affected. The extra spread can be viewed
as a protective buffer from the expected rise in interest rates.
Economic growth matters
If this buffer is ignored and changes in Treasury yields are
simply added to current cap rates, the results are scary.
This simplistic method isolates the relationship between
cap rates and property values, but fails to account for other
factors that have the potential to offset value declines.
Real GDP growth is expected to strengthen from an anemic
2.1% in 2013 to a more robust 2.7% in 2014 and to an
intermediate-term trend of 2.8% over the 2015 to 2019
period. The resumption of stronger growth is expected to
reduce the unemployment rate as well to below 6% by
2018. The expected economic and jobs strength has
positive implications for real estate occupancies, rent
growth, and operations that can help offset, at least
partially, any adverse price impacts of rising cap rates.
Thus, the feared environment does not have to translate
into catastrophic real estate performance.
Exit assumptions matter
Common underwriting practices should also mitigate
investor worries. Transaction professionals often use a
“rule of thumb” in determining terminal cap rates, where
exit cap rates are assumed to be 50 to 100 basis points
higher than going-in cap rates over the holding period.
This practice typically reflects the aging (finite life) of the
property. As a result, cap rate increases are typically
accounted for in return expectations, thus, eliminating
some of the potential “surprise” associated with them.
2
Cap rates rising: Fear and loathing in real estate
Simple scenarios
Perhaps the simplest way to isolate the impact of rising
cap rates on real estate performance is to examine some
scenarios using a simple internal rate of return (IRR) model.
In our examples, we analyze ten holding periods, ranging
from one to ten years, each using the same assumptions,
but with various exit cap rates. By varying the exit cap rates,
we can isolate the effects of rising cap rates over the
different holding periods.
The property purchase price, or initial value, is assumed
to be $100. The going-in cap rate is assumed to equal
6.4% which is the average for 2012 NPI transactions. For
simplicity, the model assumes that annual net operating
income (NOI) growth equals 2.4%, the consensus inflation
expectation from the Blue Chip Economic Indicators® over
a 10-year horizon. Research indicates that NOI growth has
historically been able to keep up with inflation, but only with
considerable capital expenditures. 4 A capital expenditure to
NOI ratio of 33% is used, taken from historical NPI data.
Consensus expectations show that the 10-year Treasury yield
will reach 3.4% in 2015 and average nearly 5.0% during the
latter half of the ten year horizon. With the current 10-year
yield at roughly 1.8%, this amounts to increases of 160 to
320 basis points. We assume that the current extra 200
basis point cap rate spread will absorb some of the increase
and test potential cap rate increases of 0 (the base case),
50, 100, and 150 basis points.
Not surprising, all else equal, larger exit cap rate increases
above the base case result in poorer overall investment
performance. But, the deterioration is not uniform across
time. The exhibit highlights that the timing of cap rate
changes matters a lot. In the near term, cap rate increases
have a dramatic impact on property performance, but as
time passes, each of the scenarios’ IRRs approaches the
base case. This occurs because of the 2.4% per year growth
in NOI and the compounding associated with it which act as
protection against adverse movements in cap rates. As long
as NOI is growing, time will mitigate the negative impact of a
rising cap rate environment.
Magic of compounding
The importance of compounding annual NOI growth can be
further highlighted by examining its impact on end-of-holdingperiod values. In Exhibit 5, we show some scenarios for
different NOI growth rates using the +100 basis point exit
cap rate scenario.
Exhibit 5
Initial and end of period values using different NOI growth assumptions
W Initial value W 1% growth W 2.4% growth W 4% growth
$130
120
110
100
Time heals all wounds?
90
Results are shown in the exhibit below where the base case
IRR of approximately 6.7% is subtracted from each of the
scenarios across all holding periods. 5 The purple line at 0%
represents the base case IRR subtracted from itself.
Exhibit 4
IRR differentials for 4 exit cap rate scenarios
W +150 bps W +100 bps W +50 bps W +0 bps
5%
0
-5
-10
-15
-20
1 Yr
2 Yr
3 Yr
4 Yr
5 Yr
6 Yr
Holding period
7 Yr
8 Yr
9 Yr
10 Yr
Source: TIAA-CREF; Author’s calculations
This is a hypothetical illustration, based upon the assumptions
described above. These results shown are for illustrative purposes
only and do not reflect actual (product) performance. Changes in the
assumptions will result in changes to the results shown.
80
1 Yr
2 Yr
3 Yr
4 Yr
5 Yr
6 Yr
Holding period
7 Yr
8 Yr
9 Yr
10 Yr
Source: TIAA-CREF; Author’s calculations
This is a hypothetical illustration, based upon the assumptions
described above. These results shown are for illustrative purposes
only and do not reflect actual (product) performance. Changes in the
assumptions will result in changes to the results shown.
The results show the powerful impact of compounding
annual NOI growth on property values. With NOI growth
equal to consensus inflation expectations (2.4%), end of
period property value (the green line) is anticipated to
exceed initial value (the purple line) in Year 6. Greater NOI
growth (4%) accelerates the breakeven point to Year 4
(where the blue line exceeds the purple line). More modest
levels of income growth (1%) prolong the pain; the breakeven
is not reached after 10 years (the black line does not cross
the purple line), in fact, it is not reached until Year 14 which
is not shown in the exhibit. Stronger than average NOI
growth is a reasonable assumption here because the
higher Treasury yields that we are expecting will only occur
if economic growth strengthens. NOI will also benefit from
the generally limited construction underway.
3
Cap rates rising: Fear and loathing in real estate
So, investors can do better by preferring properties and/or
markets that exhibit solid NOI growth. This clearly has
relevance for investment and market selection strategies.
Evidence suggests that higher NOI growth tends to occur
with higher probability in high-barrier-to-entry (lower cap
rate) markets. 6 Thus, higher-yield, bond-like (higher cap
rate, limited NOI growth) property investments may not
be as “safe” as sometimes perceived, particularly when
low NOI growth rates and rising cap rates are a concern.
This is an interesting implication given the current debate
surrounding the desirability of low versus high cap rate
investment in today’s real estate environment.
Bottom line: keep calm and carry on
Fears that the eventual rise in interest rates will result
in higher cap rates and declining property values are only
justified if everything else is assumed to be unchanged.
While this assumption might seem reasonable, it
oversimplifies the more complex nature of reality and
ignores factors that have the potential to offset value
declines. As a result, investor fears are likely exaggerated.
In the paragraphs above, we explain that, first, cap rate
increases are typically accounted for in return expectations
through common underwriting practices and current cap
rate spreads are above average. So, investors are prepared
for some upward movement in cap rates. Therefore, they
should not fear the cap rate increases that they expect,
only the ones that they do not expect. Second, real estate
performance is less sensitive to cap rate changes as the
investment horizon lengthens. But, if cap rates rise in line
with interest rates, they can have a dramatic impact on
property performance in the near term. Thus, the timing
of cap rate changes matters and time has the potential to
heal most, but not all, wounds from rising interest rates.
Third, compounding annual NOI growth has a powerful
impact on property values; the stronger the growth,
the greater the protection against adverse movements
in cap rates. This last point has important implications
for property and market selection, and suggests a strong
preference for investments with solid NOI growth, further
validating our target market selection process. 7 It also
suggests that higher-yielding, lower-growth investments
may not be as alluring as some believe.
The changes in quarterly Treasury yields lagged one, two, three, four, and five quarters were used in separate OLS regressions to explain changes in
cap rates. None of the equations produced significant t-statistics for the change in Treasury yields.
2
As evidenced by our own cap rate model, forecasting cap rates is a complex process that incorporates a variety of variables. Furthermore, it is difficult
to forecast beyond a short time horizon with consistent accuracy. See Martha S. Peyton, “Capital Markets Impact on Commercial Real Estate Cap
Rates: A Practitioner’s View,” Journal of Portfolio Management, Special Real Estate Issue 2009.
3
Note that using the full data sample from 4Q82 to 4Q12 results in a lower long-term average cap rate spread because 10-year Treasury yields
exceeded transaction cap rates through much of the 1980s, resulting in negative cap rate spreads. The full-sample average equals 225 basis points.
4
See Mike Kirby and Peter Rothemund, “Sector Allocation for the Long Run,” Sector Allocation—Special Report, Green Street Advisors, December 4, 2011.
5
See Joseph L. Pagliari, Jr. & James R. Webb, “Past and Future Sources of Commercial Real Estate Returns,” The Journal of Real Estate Research,
Fall 1992.
6
See Mike Kirby and Peter Rothemund, “REITs for the Long Run,” Heard on the Beach, Green Street Advisors, January 31, 2013, and Mike Kirby and
Peter Rothemund, “Do Quality Snobs have a Point?,” Heard on the Beach, Green Street Advisors, November 30, 2010.
7
See Martha Peyton and Edward F. Pierzak, “Winning Markets: Persistence in Target Market Portfolio Performance,” TIAA-CREF Global Real Estate,
February 2013.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which
this information may relate. Certain products and services may not be available to all entities or persons.
Past performance does not guarantee future results. Investments in real estate are subject to various risks, including fluctuations in property values,
higher expenses or lower income than expected, and potential environmental problems and liability.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of
companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers
Insurance and Annuity Association® (TIAA®).
Teachers Advisors, Inc., is a registered investment adviser and wholly owned subsidiary of Teachers Insurance and Annuity
Association (TIAA). TIAA, TIAA-CREF, Teachers Insurance and Annuity Association, TIAA-CREF Asset Management and
FINANCIAL SERVICES FOR THE GREATER GOOD are registered trademarks of Teachers Insurance and Annuity Association.
© 2013 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue,
New York, NY 10017
1
C10181
184925_321301 (04/13)