Many investors are concerned that the raising of interest rates by the Fed will lead to an increase in cap rates, but that isn’t necessarily the case.
The Fed raises interest rates and shows no signs of stopping
Last week, in an effort to combat rampant inflation, the FOMC unanimously voted to raise the target Fed funds rate (FFR) by 50 bps and made it apparent that this will not be the last time. The Chicago Mercantile Exchange anticipates five more rate hikes this year, projecting a target FFR between 275-325 bps by the end of the year. The Fed has also signaled that it plans to reduce its balance sheet at a rate of $47.5 billion per month starting in June and then increase that rate to $95 billion in September, adding even more upward pressure on interest rates.
The impact of these decisions is most evident in the 10-year US treasury yield which has risen nearly 125 bps over the past two months and is now trading at the highest level since 2018. Incoming rate hikes have caused many investors to worry that the cap rate compression we’ve experienced over the last year and a half is coming to an end, but that might not be the case.
Historically, capitalization rates for retail assets have demonstrated only a slight positive correlation to interest rates, 0.24 to be exact. Fortunately for investment sales clients, the statistical significance is negligible. Given the unique characteristics of each property, it can be difficult to identify any specific market level variables that determine what price an asset will fetch when it’s time to sell. However, owners of retail assets concerned about rising interest rates can find comfort in a few key places: market fundamentals, investor demand, and the past.
Maintaining a balanced perspective on the market
In Q1 2022, net absorption was 24.1 million square feet, a 530% increase over the previous year. Combined with an average vacancy rate of 4.5% and 1.2% rent growth over Q4, retail fundamentals have remained historically strong. Using JLL transactions as a proxy for market demand, the average number of bids per deal in Q1 was 36% from Q4 2021, and the average bid-ask spread on winning offers was 8.7% higher than initial BOV estimates. Indicating an increase in interest and competition amongst active buyers of retail assets.
When we look at historical data, we can see that although interest rates are higher than we’ve grown accustomed to over the past two years, they still remain at historically low levels. As of May 5th, the market yield on 10-year treasuries is roughly 3% and all-in commercial debt rates are between 4.50-4.75%, both of which are under the 30-year average.
Expectations going forward
With rate hikes on the horizon, it’s likely that we will see more clients lean towards an expedited, targeted marketing process in order to avoid re-trades stemming from debt market volatility. Sectors that have been “priced to perfection” such as industrial and multi-housing will be more directly impacted by increasing interest rates relative to multi-tenant retail. Because of this we may see increased interest from investors who aren’t traditional retail market players. As public equity markets continue to struggle and roughly $248 billion of dry powder remains on the sidelines, retail CRE will serve as safe haven from inflation while still offering competitive returns.
Source: “Retail Cap Rates vs The Federal Reserve“