As the Federal Reserve begins to implement interest rate cuts, the question arises: how will these changes affect real estate capitalization rates? The interplay between short-term policy rate adjustments and the longer end of the yield curve significantly influences real estate investment activities.
A recent analysis by CBRE Econometric Advisors (CBRE EA) has tracked capitalization rates since 1995. The findings reveal that a 100-basis-point change in the 10-year Treasury yield leads to varying cap rate adjustments: industrial assets experience an average movement of 41 basis points (bps), retail assets see an increase of 78 bps, while office and multifamily assets average adjustments of 70 bps and 75 bps, respectively.
The relative resilience of industrial assets can be attributed to sustained investor demand for logistics properties over the years. Before 2010, industrial real estate did not enjoy high demand, resulting in less pronounced cyclical cap rate compression. However, post-pandemic dynamics, characterized by robust fundamentals, have propelled demand for industrial spaces, thereby keeping cap rates from escalating as significantly as those in other sectors. This surge in demand has bolstered net operating income (NOI) growth and diminished risk premiums for industrial properties.
Factors Influencing Cap Rates
CBRE EA projects that the U.S. economy will sidestep a recession as inflation trends toward the Federal Reserve’s 2% target. The expectation is that the 10-year Treasury yield will remain below 4% for the remainder of 2024 and potentially decline to the mid-3% range by 2025. Such a decrease in Treasury yields is expected to exert downward pressure on cap rates, as the reduced cost of capital encourages investment activity and enhances asset values.
Furthermore, this optimistic economic scenario is anticipated to support robust commercial real estate fundamentals—excluding the office sector—fueling rent growth and income returns. This, in turn, may further push cap rates downward. Several other factors that can influence cap rates include the risk premium (the yield spread compared to risk-free bonds), GDP growth, foreign exchange rates, inflation, and the effects of the Federal Reserve’s balance sheet on market liquidity. Notably, structural shifts like the rise of remote work have a profound impact on office sector cap rates.
Broader Trends and Future Projections
While Treasury yields and rental rates are primary influencers of cap rates, significant contributions come from the risk premium and GDP growth. Historically, the spread between cap rates and Treasury yields widens during economic slowdowns and narrows during periods of recovery. CBRE EA forecasts suggest that cap rates may decline more slowly compared to past cycles and stabilize at higher levels than those observed before the pandemic. This shift is influenced by persistent federal budget deficits and ongoing economic growth.
Looking ahead, cap rates are expected to begin a gradual compression starting in the fourth quarter of 2024, with a more pronounced decrease anticipated in 2025. The projections estimate that from their peaks to the end of 2025, industrial cap rates will decrease by 40 bps, retail by 35 bps, multifamily by 25 bps, and office by 20 bps.
In the long term, stabilized cap rates are expected to settle at 4.5% for industrial and multifamily properties, 5% for office spaces, and 4.6% for retail, all remaining above pre-COVID levels.
Thus, it is recommended that investors focus on broader macroeconomic drivers that affect Federal Reserve policies rather than solely the pace or magnitude of interest rate cuts to comprehend cap rate fluctuations.
Early indications of cap rate compression in the multifamily and industrial sectors have emerged, and notable variations are anticipated across different property types, including within the challenging office sector. While macroeconomic factors will guide the direction of cap rate movements, the degree of these shifts will be contingent upon the relative strength of each market and asset. Consequently, strategic market and asset selection will become increasingly vital for investors in the current economic cycle.
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