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Leveraged Breakdowns

Do Cap Rates Follow Interest Rates?

This is a very interesting time to begin your real estate private equity career path. In the past year (2019) we have seen interest rates begin to climb up from historic lows, then suddenly turn back down to historic lows again. One of the big questions that always lingers in the REPE industry is whether or not cap rates will follow interest rates. As an analyst, part of your job will be to make educated guesses as to exit caps for properties as you build your real estate private equity model. Whether cap rates follow interest rates is a complicated question.

Where do Cap Rates Come From?

Intuitively, cap rates are the unleveraged yield that real estate investors demand for a particular property. You know the formula: NOI / Cap Rate = Value. Or put another way, NOI / Value = Cap Rate. If you’ve ever read a property appraisal (and you should, and here’s why) or if you remember from one of your finance classes, cap rates are really made up of three components: The risk free rate (US Treasuries), the equity yield (what investors expect to earn on this type of investment), and the debt yield (prevailing interest rates and terms for borrowing). From this definition you can see that two of the three components are “interest rates.” So if those rates move significantly, cap rates should follow, right?

Free Market Matrix

Don’t forget that each of those three components is a market in and of itself. In other words, supply and demand drive the market, and competition is at the root of all of them. So when US Treasuries began their climb in late 2018 and into the first half of 2019, you might expect debt rates to follow, which they generally did. But did cap rates trend up as well? Not at all. Why not?

There is an abundance of investment capital sitting idle in US REITS and private equity funds waiting to find good investments. That means there is an abundant demand for investment real estate. If the supply does not keep up, that means prices for quality assets climb. In the context of the cap rate components (risk free rate, equity rate, and debt rate), if the risk free rate climbs and the debt rate climbs, the only way to hold cap rates steady is to offset the increasing risk free and debt rate with a lower equity rate. If you have equity investors clamoring to find quality investments, their return expectations can begin to slide lower in order to deploy capital.

Another way to massage the components of the cap rate is to adjust how much debt and equity is applied to the investment. If the industry norm is to use 40% equity and 60% debt, investors may opt to use more equity in a rising interest rate environment in order to justify a flat cap rate.

Your Private Equity Real Estate Career Path

This is an interesting time to begin your REPE career. Projecting interest rates and cap rates into the future is always like looking into a crystal ball. Nevertheless, your real estate private equity model will require some assumption about exit cap rate, and your sensitivity analysis should almost always include a testing of how sensitive the returns are relative to changes in cap rates. As you build your models and discuss assumed exit caps with managers, keep in mind where cap rates come from, and how each component is its own marketplace. That perspective may just be the difference between following the herd, and spotting a trend you can capitalize on.

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