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Making Sense of Negative Cap Rate Spreads

Hawkeye Wealth Ltd. • Nov 25, 2023
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In this edition of the Birds Eye View, we cover what cap rates are, their relationship with interest rates, then dive into why seeing negative cap rate spreads is so strange.

In the DC Comic book universe, there is a planet named “Htrae” (Earth spelled backwards). On Htrae, everything happens opposite to expectations.  Up is down, hello means good-bye, and people qualify for leadership only if they can demonstrate a sufficient level of stupidity. On Htrae, one of the best selling financial instruments are bonds that are guaranteed to lose you money.

While we aren’t quite to the level of Htrae (with the possible exception of government leadership), the commercial real estate market here on Earth has some truly backward features at the moment, with the most notable being negative cap rate spreads in some markets and asset classes.

In this edition of the Birds Eye View, we cover what cap rates are, their relationship with interest rates, then dive into why seeing negative cap rate spreads is so strange.


What are Cap Rates?

Cap rates (short for capitalization rates) are a commonly used metric used to evaluate the profitability (and indirectly, risk) of commercial real estate investments. The equation for calculating cap rates is as follows:

Cap Rate (%) = Net Operating Income (NOI) ÷ Market Value of property

The cap rate thus indicates the annual return of the investment if you bought the property with no debt. More risky assets will generally have a higher cap rate (out of favour asset class, less desirable location, vacant or older buildings), while more stable properties will have a lower cap rate.


The relationship between Interest Rates and Cap Rates
Interest rates and cap rates usually run together, with a variable spread between them. When interest rates rise, cap rates tend to increase as well.  Higher interest rates mean higher borrowing costs, such that investors will require a higher return on their investment to compensate for the increased cost. When interest rates are low, cap rates decrease since borrowing costs are lower.

While the chart below is only current to Q1 2023, it does an excellent job at portraying historical cap rate spreads between the relevant interest rates, and the recent narrowing of that spread:

The 15-year historical average spread between the 10-year treasury yield and cap rates in Canada has been ~400bps.  In other words, investors have historically required an average of 4% additional yield over the risk-free rate to be induced to invest in commercial real estate.

While the above averages include all markets and asset classes, there is considerable variance across these.  For example, Altus Group data from Q3 2023 indicates that there is more than 200bps of spread between the cap rates for suburban multi-family residential (4.66% cap rate) and downtown class “AA” office (6.69% cap rate).


Data from Colliers (see right) also shows the considerable variance between average national cap rates based on market.


On average, cap rates in Vancouver tend to be lower than cap rates in Alberta.  In all markets, the cap rate spreads are considerably below historical averages.


If history is a guide and interest rates stay higher for longer as has been forecasted by the Bank of Canada, we anticipate that asset prices will fall and cap rates will likely rise over time and settle in closer to historical averages.

Introducing the Negative Cap Rate Spread
From March 2023 (when the above charts were produced) to now, 10-year bond yields have risen aggressively on the strength of ‘higher rates for longer’ rhetoric from the Bank of Canada, to where they now sit at 3.725%.  Cap rates have edged up, but multi-family cap rates have remained sticky due to strong market fundamentals. In short, the spreads have narrowed even further.


So where does that put us? According to Colliers Q3 Canada Cap Rate Report, some markets and asset classes are firmly in negative cap rate spread territory. For example, in Vancouver, multi-family apartments have been trading at cap rates of between 3.25% - 4.00%.


It begs the question of why investors are choosing to invest in a real estate asset at a going-in cap rate of 3.5% if they can go get a 10-year, risk-free bond at 3.725%.  Said another way, why do some investors view multi-family assets in select markets as having less risk than the risk-free rate? It’s a strange world indeed.

A bet on the future
Right or wrong, investors choosing to invest in a negative or narrow cap rate spread deal are making a bet on the future.  Here is the rationale as we understand it:


  • A bet on rent growth. Over the last 18 months, rental rates have grown at unprecedented levels, in large part due to similarly unprecedented immigration levels and low supply.  If rental rates continue to rocket and owners can adjust rates (not a given with tenancy laws), the Net Operating Income of an asset could potentially keep up with the higher cap rates and financing costs to keep property values increasing or stable.


  • A bet on price appreciation/falling rates. This seems precarious to our team, but there are people out there that feel that with the pent-up demand in the market, prices will continue to rise irrespective of some of the fundamentals at the property level.  Alternatively (or conjunctively) they feel rates will inevitably fall.


  • A bet on value-add. Investors think that they can drive enough improvement to command higher rental rates, off-setting the financing costs and depressed prices from increasing cap rates. It’s a common strategy, though it can be much harder to successfully implement in this rising rate environment.

Conclusion

Now more than ever, with cap rate spreads at historically low levels, investors have reason to question whether they are being appropriately compensated for the risk they are taking on.

In our view, it is likely that borrowing costs will catch up with investors and cap rates across most markets and asset classes will rise into 2024.

We always have our ear to the ground and have reviewed many dozens of potential deals in 2023. When we find one that pencils to our underwriting standards, including higher than current exit cap rates, we are excited to share these opportunities with our clients. However, we recognize that these deals are rare in this environment.


So instead of trying to force successful investments in an odd market, where people invest in risk-bearing assets at below the risk-free rate, we are content to look toward alternative investment strategies (such as private credit) until up is no longer down and the world makes sense again in commercial real estate.




Sources

- Colliers Q3 Canada Cap Rate Report / Colliers Q1 Canada Cap Rate Report

- MarketWatch - Canadian 10 Year Bond

- Altus Group Report Q3 2023


Forward Looking Statements

This material is not intended to be relied upon in connection with a purchase of securities. This article is for informational purposes only and do not constitute an offer to sell or a solicitation to buy any securities referred to herein. This article includes forward looking statements that do not constitute a guarantee of future performance and are based on assumptions and estimates using the data and information provided.

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