Looking deeper into real estate cap rates within figures 1 and 2, we can see that cap rates have outperformed the 10-Y T-bill average since 1986. However, not all property types have performed equally. Beginning in 1994, the multifamily cap rate has remained well below other property types, providing less risk while still outperforming the 10-Y T-bill. Over the long-term, the historical average spread between the multifamily cap rate and 10-Y T-bills stands close to 2.15%, or 215 basis points. More recently, since the 2008 Great Recession, the spread has increased close to 3.15%.
What do we expect for the next 5 years?
We expect the current value cap rate (appraised properties) to remain low from 2021-2026 with an annual average of 4.8%. The transaction cap rate (sold properties) will continue its recent historical relationship of being about 1%, or 100 basis points, higher than the current value cap rate. The same is true for the cap rate by property type. This means that multifamily assets will continue to have lowest cap rate for commercial properties.
We expect the 10-Y T-bill will remain just below the 2% mark this year (2021). However, as the base rate rises starting next year, expect the yields on 10-Y T-Bills to rise to an average of around 2.5% from 2021-2026. We also expect cap rate and T-bills to peak during 2023.
We expect an annual average spread of 2.29% from 2021-2026 in favor of cap rates, which is better than the long-term average of 2.15%. We also expect that an increase in 10-Y T-bills will have little impact on cap rates other than a narrowing but healthy spread during the same period. Here is some of our reasoning.
- Commercial and residential real estate as investment vehicles remain attractive and are expected to remain the preferred investment vehicle for a couple more years. The demand for real estate investment is expected to keep cap rates low. Multifamily and industrial will lead the demand this year. Office space will see an above average bounce back in fundamentals starting in the middle of next year.
- Mathematically, data from recent years shows that a 1% increase in 10-Y T-bills increases the cap rate by about 0.30%. Our outlook is conservative, in that, we believe it would be around a 0.50% increase in cap rate.
- Given the fact that the global economy remains weaker than the U.S., the United States market is expected to be seen as a “safer” economy to attract capital from around the world through 2024. A portion of that capital will continue to flow into real estate investments, keeping demand healthy.
- The increase in interest rates points to the Fed’s increased confidence in the U.S. economy. Real estate fundamentals have a high correlation (of about 85%) with job growth. The confidence in expanding job growth will carry the real estate fundamentals to a healthy territory during the outlook, keeping cap rates low.
- Years of a near-zero federal funds rate and multiple economic stimulus to fight the economic impact of the pandemic has threatened the U.S. economy with high inflation rates. But the real estate investment has always been thought of as a hedge against inflation. Therefore, expect low cap rate despite the increase in risk-free rates.
It is our perspective that the historical relationship between cap rate and the 10-Y T-bill will continue. However, even though we expect 10-Y T-bills to peak around the 3% range in 2023, we foresee only a slight increase in cap rates and the spread will narrow only when compared to recent history.