What’s More Important in CRE Investments – Cap Rates or Interest Rates?

Capitalization rates (cap rates) and interest rates are always an interesting point in discussing what is more important to managing potential maturity risk losses for commercial real estate (CRE) property operating businesses.  On the one side, sponsors and buy-side broker-dealers obsess over capitalization rates because they are trying to squeeze as much as the market will bear to sell a given asset.  Sell-side broker-dealers, lenders and investors are concerned by cap rates to be sure, but interest rates can be a whole lot more important – in fact, they can be the whole ballgame when it comes to 1031 exchange investment vehicles like Delaware Statutory Trust (DST) transactions where a property or properties are held for 10 years whether you want to, need to or not.

Currently, we live in a market where cap rates are quite low and that doesn’t speak to them having the potential to go any lower on CRE transactions.  They are likely to go up and if you are looking at a zero-coupon DST transaction, then everything seemingly depends on what that cap rate will be in 10 years and nobody knows.  All of it is done on the assumption things will be the same then as they are now.  What are the odds of that being the case?

In a healthy economy, asset obsolescence is a fact of life and is part of the creativity engine that makes market economies work and all other forms of market organization fail.  Today we live in the Information Age and that means advances in technology can get to the market pretty quickly compared to a hundred years ago when the Pony Express had to bring the information.  From a practical viewpoint that means a market disruption (or series of disruptions) is likely to occur over that 10-year mandatory holding period and that means that CRE deals that are dependent upon the exit cap rate being agreeable are at a special category and level of investment loss risk.

Interest rates however represent a potential outcome that could be more important as even if the cap rates are too high for 100% recovery of the promised yield, debt provides investment leverage and that means higher interest rates beyond the cap rate ceiling limit may still provide a workable scenario for 100% recovery when the cap rate cannot.

I think it means interest rates are the issue that counts.  What about you?

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