Why are Interest Rates Rising Faster than Cap Rates?
Hip Hip, another interest rate hike. But seriously, the Fed’s interest rate hikes are indirectly impacting the commercial interest rates which in theory should cause cap rate expansion and lower pricing. So why are cap rates and pricing not moving at the same rate as interest rates?
I believe it is due to a lag effect. Specifically, I believe it is due to two underlying variables. First, cap rates are based on historic trade rates. In other words, cap rates are quoted on transacted sales, so if there is a halt in sales cap rates can remain stagnant.
The second reason, which I think is more pertinent in today’s environment, is due to the market cycle that preceded these hikes. In other words, Real Capital Analytics reported the second highest multifamily transaction volume for 2022 Q1 at $63 billion. With so many transactions at record setting pricing, investors 1031 into another investment in order to avoid major tax implications. I spoke to several investors who were facing a $5m+ tax hit due to the sale of their property. They proceeded to tell me that they would gladly overpay by up to $4m on another property via 1031, just to avoid the tax hit. This mindset not only kept properties transacting at a much higher rate than they should have commanded, but also kept cap rates stable despite initial interest rate hikes.
Once the large volume of 1031 money cycles through the market, I believe we will see a significant decrease in pricing, in turn cap rate expansion. And if you read my previous post on whether or not we should continue using cap rates as the sole way in which we determine value, I think it is safe to say I am a little gun-shy on using the “going” cap rate in my evaluation calculations:) Are you still seeing 1031 money in your markets, or do you think the majority of money has already been put to play?