March 6, 2018
Reversion to the Mean
In today’s value add and opportunistic commercial real estate market, investors have one key underwriting assumption that will dictate the success or failure of their equity investments – exit cap rates.
Value-add and opportunistic real estate investing is driven by three basic metrics:
Future Value = Rent Increase + Occupancy (Future NOI) / Future Cap Rate
A huge part of the success over the last 10 years in the value-add and opportunistic space is that even if the investor did not execute their plan well, cap rate compression allowed the investment to be successful.
When underwriting commercial real estate, it is much easier to predict future rents and future occupancy, based on the asset, the market, the surrounding demographics, the market trends, than future cap rates.
However, the key driver of value added investing is the exit cap rates.
What Drives Exit Cap Rates
This question has been an open debate for some time. There are a variety of opinions that include:
- Interest rates
- Flow of funds
- Consumer confidence
- The historical delta between cap rates and the 10-Year Treasury
While we are not going to fully reopen this debate, based on our 25+ years of experience it’s clear to us the two primary factors are:
- Interest rates
- Flow of funds
Today there are two basic drivers that are easy to agree on:
- Interest Rates: They are coming off all-time lows and they now appear poised to increase.
- Flow of Funds: There is currently a lot of capital in the system. It’s hard to see materially more capital entering the market.
At this point in the cycle, it is reasonable to assume that interest rates will increase at a greater rate than flow of funds. Therefore, value-add and opportunistic investors need to ask themselves one basic questions when it comes to interest rates.
Question: Will interest rates over the next 3-5 years look like the interest rates of the last 10 years, or will the next 3-5 years look more like the last 30 years?
Answer: Most of the sponsor underwriting we see today is based on the answer of: “The last 10 years”. This answer is basically saying:
- “It’s different now”
- “It’s a new paradigm”
JCR Answer: At JCR, we believe the last 10 years could well be a historic anomaly, brought on by one of the greatest recessions and financial crises of our time, and that eventually interest rates will revert to the historical mean (the last 30 years).
Cap Rates and Interest Rates
30-year statistics Mean Current Delta Lowest year
Multifamily 7.54% 4.75% 2.79% 2016
Office 7.81% 4.91% 2.90% 2007
Industrial 8.28% 5.50% 2.78% 2016
Retail 7.95% 5.55% 2.40% 2016
10-year statistics Mean Current Delta Lowest year
Multifamily 5.71% 4.75% 0.96% 2016
Office 5.96% 4.91% 1.05% 2007
Industrial 6.72% 5.50% 1.22% 2016
Retail 6.58% 5.55% 1.03% 2016
We have also viewed the 10-Year Treasury and the Fed Funds rate over this same time.
10-Year Treasury Mean Current Delta High Point
30-Year Statistics 5.18% 2.36% 2.82% 9.63% (1987)
10-Year Statistics 2.97% 2.36% 0.61% 5.14% (2006)
The Key Takeaway:
If you believe the future will look like the last 10 years, stress cap rates 50-100 basis points (off of 2016 low’s).
If you believe the future will look like the last 30 years, then cap rates need to be stressed more than 100 basis points.
Over the next three years, it is safe to say that interest rates will increase and the flow of funds cannot/will not increase significantly. Thus, if flow of funds stays constant or decreases, and interest rates rise, then cap rates must rise as well.
In the end, we believe everything reverts to the mean. While we don’t know for certain if that is the 30-year mean or the 10-year mean, our view is that cap rates have nowhere to go but up and will catch many equity investors off guard. We prefer to take the view that the reversion will be to the 30-year metrics, versus the 10-year metrics. If we are wrong, we prefer to be wrong to the upside.