Cap Rates on the Rise Again.

First American Financial Corporation research suggests that cap rates may finally begin to regain some of their worth.

With regard to the first quarter of 2022, the company’s potential capitalization rate (PCR) model “estimates capitalization rates based on the historical relationship between interest rates, rental income, current occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends.”

As the corporation pointed out, supply chain problems brought on by the epidemic have prevented inflation from being the “transient” phenomenon that the Federal Reserve had projected it would be. The Federal Reserve eventually began tightening monetary policy, most recently increasing its benchmark interest rates by 75 basis points, the biggest one-time increase since 1994.

The 10-year Treasury note saw a spike as a result, rising from around 1.7 percent in early January 2022 to a high of 3.48 percent at the time of the rate hike. Yesterday’s 10-year closing rate was 2.97 percent. First American predicts that the 10-year yield would likely increase due to further anticipated quantitative tightening—the Fed lets bonds it owns mature and then removes them from its balance sheet, eliminating the extra money it had injected into the economy.

Investors utilize the 10-year as a relatively risk-free method of investing and to assess the worth of riskier investments, such as commercial real estate. For an investment to be considered worthwhile of the risk, it must now yield higher returns.

According to Xander Snyder, senior commercial real estate economist at First American, “since capitalization (cap) rates are a measure of return on an asset, higher “risk-free” rates mean sellers will need to lower their price expectations or increase cash flow, if that’s an option, to entice buyers seeking competitive yields, which should also push up cap rates.

Although cap rates are currently close to record lows, the PCR model predicts that cap rates will eventually rise due to slower price increases. However, not every form of CRE property is in the same situation. Snyder noted,” “Multifamily and industrial assets set first-quarter price growth records, increasing at a faster rate than any other first quarter in the past 20 years, while office and retail assets were a drag on overall CRE price growth in the first quarter. However, a record amount of industrial square footage is currently under construction and expected to come to market later this year, which may slow price growth for industrial assets and put further upward pressure on the potential cap rate as the year progresses. ”

First American stated in April that cap rates were set to decline further at the time, but circumstances have since changed.