By Jim Costello on December 15th, 2016
Despite initial excitement over the very notion that the Federal Reserve was raising interest rates, the market responded in a moderate manner yesterday with minor movement in the 10yr UST. Little wonder, as the attention is no longer focused on the monetary policy from the Fed but instead on the fiscal policy coming from the incoming Trump administration and Congress. That and whatever happens next on Twitter, of course.
Since the election, the 10yr UST has moved up 60 bps and is up 110 bps since the low point set in July 2016. The natural inclination for many investors may be to see these increases and assume that cap rates will experience a similar increase. However, even if interest rates increase further, to 3% or more in the coming year, it is not a foregone conclusion that cap rates will spike up in response.
Movements in Moody’s Baa corporate bond yields tend to mirror those of cap rates, and daily trends since the election suggest that investors are viewing the coming changes to fiscal policy favorably. Since the election, the spread between the 10yr UST and these higher-yielding corporate bonds has narrowed by 30 bps. There is reason to believe that cap rate spreads to the 10yr UST could behave in a similar manner as interest rates increase.
Fundamentally, the impact of the stimulative pressure of tax cuts and infrastructure spending should reduce investor perceptions of risk in the market, and thus to narrower spreads between cap rates and the 10yr UST. Even with no changes in market rents, the net income produced by property investments will increase given lower tax rates at the corporate level. Combine that higher profit margin with the perception that a number of underemployed people will suddenly be building roads and bridges, and one might expect property income to grow for some property types as well.
That, at least, is what the market is expecting. I think the tax impacts will certainly have a positive impact on corporations. It is not clear, however, that the politics around infrastructure spending plans will quite have the WPA-style impact on the labor markets that some are hoping.
The net effect from all of this is that if interest rates stabilize in this 2.4% to 2.6% range that has been evident since Thanksgiving, then the market is back to the 2014 levels for interest rates. For commercial property cap rates, the average spread to the 10yr UST at that time was 440 bps and the spread is now at 390 bps using our preliminary November 2016 cap rate figures. A 390 bps spread is in line with long-run averages, a level which may narrow further.
Those spreads in 2014 were set in a time when investor perceptions of risk were higher and growth expectations were lower. Both of those features should help narrow cap rate spreads. Unless the market posts further, sharper increases in interest rates, the interest rate changes since the election could be a non-event for cap rates.