Author: Randall Zisler and Matthew Zisler
“Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” — John Maynard Keynes, A Tract on Monetary Reform
“‘Very Serious People’ … the way respectable opinion keeps demanding utterly foolish policies … someone distinguished by his faith in received orthodoxy no matter the evidence.” — Paul Krugman, winner of the Nobel Memorial Prize in Economic Sciences, The New York Times
“It is difficult to get a man to understand something when his salary depends upon his not understanding it!” — Upton Sinclair, I, Candidate for Governor: And How I Got Licked
This is a polemic about Very Serious People in real estate. Money managers and brokerage firms, managed by Very Serious People, invest in real estate research; some even do so heavily. But too often the research is little more than propaganda — a casual validation of, not an uncompromising challenge to, the received wisdom. Seldom do real estate research directors question the received wisdom, especially when doing so may upset clients or, even worse, the investment committee. Disturbingly, some research professionals hesitate tackling the deeper, complex, more controversial issues. Often they lack the tools to do so effectively. Rather than act as tireless advocates of the truth, they abdicate their fiduciary duty for fear of alienating Very Serious People.
The leading conference organizers cultivate the Very Serious People, who are frequent keynoters that often pay to play. While doing so, they reinforce the received wisdom and intentionally, or inadvertently, may do their investors a disservice.
Very Serious People, for example, have stubbornly maintained over the past five years that interest rates (and inflation) would rise and increased interest rates would necessarily increase cap rates (and depress property prices). Many disposition brokers opportunistically exploited this myth to promote property sales.
But compelling evidence contradicts the received wisdom: Rising interest rates will not necessarily increase unleveraged property capitalization rates and, thereby, depress prices. Contradicting the old adage that real estate performance is all “location, location, location,” we find macroeconomic factors determine most of the movement in national office cap rates over time. Local real estate factors determine most of the cross-sectional variation among MSA cap rates in any one year. Furthermore, even though the property cycle is maturing, an increase over the next two years in office cap rates simply because Treasury bond yields is unlikely. In fact, we would not be surprised to see office cap rates fall further, especially in non-gateway cities, if credit spreads narrow and expected rental growth strengthens.
What is a cap rate?
The cap rate is the ratio of net operating income over the property price; it is also the sum of the risk-free rate and the credit spread minus the expected rate of growth of NOI, including other variables, such as the change in economy-wide net borrowings in relation to GDP.
Cap rate = risk-free rate + credit spread – expected growth of NOI + other variables
The cap rate is not an interest rate. Even if the risk-free rate (e.g., Treasury yields) increases, as it likely would in a booming economy with low unemployment, credit spreads might shrink and expected NOI growth rates strengthen, thereby offsetting or even swamping any increase in interest rates. Hence, cap rates could fall even in a rising interest-rate environment.
The empirical record
A scatter plot of Moody’s Baa bond yields and NCREIF unleveraged office cap rates exhibits no obvious pattern. The lack of a simple linear pattern, however, in no way suggests interest rates have no impact on cap rates. The effects of other variables can confound or even mask the relationship between interest rates and cap rates.
Reinforcing this point, the five-year rolling correlation of cap rates versus Treasury yields and Baa bond yields is not stable over time: The simple bivariate correlations alternate between positive and negative. The only times when there was a sustained and positive correlation between cap rates and Baa corporate bonds was during (1) first quarter 1988 to first quarter 1994 (rising Baa yield spreads and rising cap rates); (2) third quarter 2001 to fourth quarter 2007 (falling Baa yield spreads and declining cap rates); (3) second quarter 2009 to second quarter 2011 (falling Baa yield spreads and declining cap rates); and (4) first quarter 2014 to the present (falling Baa yield spreads and declining cap rates).
The ZCA office cap rate model
We econometrically modeled the determinants of office cap rates using multiple regression. Our results validate the expected positive role of interest rates, other factors held constant, but also indicate other variables, especially the growth of debt in relation to GDP, can swamp the effects of interest rate changes. Our model explains 92 percent of the variation in office cap rates from fourth quarter 1983 to first quarter 2015, and most of the explanatory variables are highly significant statistically.
An increase in the inflation-adjusted 10-year Treasury bond yield (REALTBOND) or the Baa bond spread over Treasuries (BAASPREAD) — a proxy for credit risk — will increase cap rates. These results are statistically significant, and the signs are consistent with theory. The impact is not strong, however. Other macroeconomic factors, including lagged cap rates, matter more.
We examined the effects of the inflation-adjusted office rent index (REALRENTINDEX), the rate of change of the ratio of total economy (less financial sector) debt to GDP (%CHDEBTGDPRATION), and the multiplicative effect of the two variables on cap rates. A rise in economy-wide debt in relation to GDP will reduce cap rates, holding all else constant; this effect is stronger the greater the real rent index is in excess of its 32-year average. This result reinforces one of the lessons of the crash: Debt matters by providing liquidity, thereby facilitating transaction volume and driving asset prices. The coefficient on the real rent index is positive but not statistically significant. A positive sign suggests when the rent index is cyclically high, investors expect a downward rental-growth adjustment.
Real estate factors are less important in determining the time path of national office cap rates. Real estate factors, however, critically affect the variation in cap rates among metropolitan statistical areas and within MSAs at any point in time.
Cap rates are a function of many variables, not just interest rates. In theory, holding other factors constant, rising interest rates should increase cap rates. Credit spreads, expected rates of growth of NOI, market liquidity and other factors are constantly changing, however, and play an important role, as well. The effects of these factors on cap rates individually and collectively have the potential to offset or completely swamp the impact of rising Treasury yields, thus confounding the relationship between cap rates and interest rates.
Randall Zisler and Matthew Zisler are principals and co-founders of Zisler Capital Associates. Interested readers should contact Matthew Zisler at email@example.com for a copy of the complete report.