Spencer Levy Spencer Levy, senior economic advisor and head of Americas research, CBRE

NEW YORK CITY— GlobeSt.com previously reported on the findings of CBRE’s recent Cap Rate Survey. With this follow-up interview, senior economic advisor and head of Americas research at CBRE, Spencer Levy, explains reasons behind the survey’s findings.

“I’m a big fan of Janet Yellen, and I’m a big supporter of Jerome Powell,” says Levy, “I think Janet Yellen deserves a lot more credit than she got for the stability of the economy during both global financial crises. I consider Mr. Powell to be largely a continuation of her policies.”

The Fed’s Role in Interest Rates and Cap Rates

Levy says the Federal Reserve is largely data driven. Although some may think the position is subject to political winds, Levy says he hopes Powell will not be, just as Yellen was not. But he adds the proof will be in the pudding when the Fed receives new data.

The Washington Post describes Powell’s job as keeping pricing stabilized, unemployment down, and inflation in check, while facing additional pressures from President Donald Trump who’s urging faster economic growth and a strong stock market. Plus, the president’s planned tariffs, 25% on steel and 10% on aluminum, will affect the economy.

Powell must balance keeping interest rates low to spur economic growth with raising interest rates to keep the economy from overheating and to control inflation. If he does that, even if in the short term increasing interest rates (which some feel will put pressure on cap rates), Levy opines that this will be good for the CRE industry in the long run.

Powell and his team determine the short-term interest rate of banks borrowing from the Federal Reserve, and with open market operations, they buy and sell bonds. Both of these activities impact the yield on the longer end of the curve.

For CRE, short-term debt is typically LIBOR-based. Longer-term fixed debt is based on swaps which is a measurement based on Treasury rates across the yield curve from two to 10 years, explains Levy. Since September, the yields on base securities have been rising. LIBOR has been going up because the feds have been raising rates. The longer end of the curve has been going up as well because there has been greater growth, and greater expected optimism, partly due to the tax reform as well as other factors, says Levy.

“But no matter how big the Fed is, the global bond market is bigger—a lot bigger,” Levy says. The global bond market includes large fund managers in the US and sovereign wealth buyers around the world. If they feel optimistic, they may shift from buying long-term bonds and go into equity. If they feel pessimistic, they may shift to more risk-free securities, such as the US Treasuries.

But, ultimately, in the past seven to eight months, the cost of debt has gone up.

Rising Interest Rates and Cap Rates 2018

“The rise in the cost of debt hasn’t been extraordinary by historic standards. There have been faster and larger increases in the past. Commercial real estate remains very attractive and the overall economy is growing faster than perhaps some people expected. So, overall we don’t see much impact on cap rates,” says Levy.

He points out that inflation and anticipated higher interest rates will add upward pressure on cap rates, offsetting the downward forces of the strong institutional and global influx of capital in larger markets. This could mean a slight upward shift in cap rates in secondary markets, which have less institutional investor funds and rely more on debt capital.

Levy stresses the cost of capital is based on the base rate, and there has been a noticeable compression in spreads over the base rate, including LIBOR, 10-year Treasuries or swaps. The trend has continued to move down for the last several years. Interest rates are rising due to the growing economy, plus inflation, with cash flow growth offsetting the increase in the cost of capital, thereby compressing spreads.

“Cap rates too often are considered to be synonyms for yield,” says Levy. “They are not.” They are a combination of the cost of capital and growth expectations. Secondary markets like Nashville, Denver or Raleigh, if they are high growth areas, even as the cost of capital is going up, they might show more resiliency than a slower growth secondary market that lacks the depth of capital pool to counter the rising interest rates, he says.

According to the CBRE report, regardless of rising interest rates, cap rates are expected to stay flat or rise but the rate of expansion will depend upon market and asset type, and the quality of the asset. For example, spec construction (property built without guarantee of a sale or rental at the time of completion) is a higher risk. But if it is in a high growth market with strong job growth and factors that bring people into the area, it can still have a lower cap rate.

Finally, Levy notes London is the number one city for global capital, although the US far surpasses the UK in global capital investments. He credits stable governments for the success of capital markets investments in the UK and the US.  “They have a stable currency. They have the strongest rule of law. They have property rights,” says Levy. “When you go outside of these countries, places can get squirrely, then you have to add a term to your investment because it’s riskier to go to a country that doesn’t have those types of things.”