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Cap Rates, Interest Rates, and Real Estate Market Valuation



Introduction

Real estate market valuations as predictors of downside risk were described in the article Real Estate Market Valuations: Predicting Downside Risk, A Back Study.


They serve a measure for the degree to which a real estate market may be over-, or undervalued. A reasonable question that comes up, is whether market valuations need to be adjusted for the current level of interest rates, considering in comparison, that cap rates and interest rates tend to move together over longer time periods. Market valuations are based on deviations from price/income ratios, while cap rates are themselves approximate inverse price/rent ratios.


Below will show that an adjustment for market valuations for the level of interest rates seems unwarranted.


Cap Rates-to-Interest Rates Relationship

Source: Mesirow Financial, Aug 2017; Source for charts: CBRE.com, Reit.com

Below is from an article in Mesirow Financial published in 2017:


“Since 1990, there has been a positive correlation between cap rates and 10-year Treasury rates (+.65); however, there have been multi-year periods of time where they have been negatively correlated. This is evidenced in the first 5-year period shown in the chart where the correlation was -0.69.”


While correlation may not always hold over shorter time periods, cap rates and interest rates do exhibit positive correlation over the long run. Since price/rent ratios are approximate inverse cap rates, it appears such would need to be adjusted for current level of interest rates, if were to be used appropriately as a market valuation measure.


Cap Rates and Valuation Relationship Across Top 100 U.S. Cities

As a side remark, below are cap rates and valuations metrics across a set of U.S. cities, the goal being to gauge the extent to which undervalued markets may correlation negatively to cap rates, as both undervalued-ness and high cap rates may be seen as characteristic of price depressed markets.


Such negative correlation of cap rates and valuation metrics across regions was indeed observed, albeit not super strong: -41% for Class C properties, -26% for Class B properties, -21% for Class A properties.

Source for cap rates: Reitnotes.com
Financial Market Valuation (P/E Ratio) vs Interest Rates
Source: SureDividend.com

The most well-known market (and company-level) valuation in financial markets are price-earnings ratios.


Financial markets valuations, proxied by price-earnings ratios show negative correlation vs. interest rates.


Specifically, Shiller PE Ratio (S&P PE10) vs 10-yr U.S. Treasury bond yield showed correlation of -0.65. S&P Price/Earnings Ratio vs U.S. Treasury bond yield showed correlation of -0.53.


There is thus a valid argument for computing 'fair valuations', by adjusting price/earnings ratios towards a correspondent level of interest rates.


Valuations and Interest Rates Relationship

Below is a chart of U.S. real estate market valuations as computed under the Real Estate Market Valuations: Predicting Downside Risk, A Back Study methodology, as well as the 10-year Treasury rate. Nominal interest rates, as proxied by the 10-yr treasury rate, have been on a decline for ~40 years since beginning of the 80s.


U.S. real estate market valuation has though stayed fairly stable around the ~6 level, such as home prices being 6 times median household income. Thus, an adjustment of market valuations as based on current level of interest rates does not seem warranted.

Source for 10-yr rate: Macrotrends.net

Assuming negative correlation of market valuation and interest rates is present in U.S. real estate, as is the case in financial markets, and given the current historical low level of interest rates, computing a measure of real estate market valuation at the current time, that is not adjusted for interest rates, may be overstating the true valuation level.


Such negative correlation is not the case. Correlation of U.S. real estate valuation country-level vs. the 10-yr Treasury rate since Q1 1975 was in fact moderately positive at 0.32. Current valuation as implied by the 10-yr rate (using intercept and slope term from correlation regression) is 5.89 – above the current actual valuation of 5.75. An overstating of the true valuation level is thus not valid.


In comparison, 2007 (Q2) valuation as implied by the 10-yr rate (using intercept and slope term from regression through then) was 6.10 – slightly below though in line with the 2007 actual valuation of 6.21.


Summary

Concluding remarks:

  • Cap rates and interest rates exhibit positive correlation over longer time periods. Such may not hold over shorter time periods.

  • Financial markets valuations, as proxied by the price-earnings ratio, exhibit negative correlation vs. interest rates, prompting the need to compute 'fair valuations', adjusting valuations towards the current level of interest rates.

  • U.S. real estate market valuation country-level, as defined as deviation from historical price-income ratios, has stayed fairly stable over a long period of interest rates decline, making an adjustment of market valuations towards current level of interest rates not warranted.


About the Author

Stefan Tsvetkov is the founder of RealtyQuant, a company that brings data-driven and quantitative techniques to the real estate industry. On a mission to add massive industry value through education, investment, technology, and analytics.


Financial engineer turned multifamily investor, analytics speaker, and live webinar host. He holds a Master's degree in Financial Engineering from Columbia University, and during his finance career managed ~ $90 billion derivatives portfolio jointly with colleagues.

Featured on multiple Podcast and Webinar events including InvestUp, Best Ever Real Estate Show, Discovering Multifamily etc. Organizer of Finance Meets Real Estate live webinar series.

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