Written by Bruce Haas, a managing partner at Industrial Redevelopment, Bruce has more than 30 years of experience in industrial real estate. Bruce has been a long-time partner with HPP.
For most investors there exists an impression that there is a direct correlation between rising interest rates and rising cap rates. However, in recent months I have seen resistance to price movement even as interest rates rise, which calls into question this theory, at least temporarily.
Typically, investors demand higher rates of return on overall equity compared to debt so that they can achieve positive leverage. This causes downward pressure on pricing. Further, fee/promoted developers will often need to sell sooner than planned to meet their IRR hurdles with these new, higher carrying costs. This further depresses pricing, hence higher cap rates.
All of these are sound logical behaviors which have occurred in previous cycles but I am seeing something different this cycle.
Recently, several studies have shown a more significant correlation and causation between cap rates and current stock market valuations. There are a few reasons for this but the condition arises mainly due to issues with investors' allocation of funds. As an example, when equities rise, large portfolios will be out of balance with their real estate holdings and may need to rebalance their allocations to align with their prospectus. Similarly, they must sell real estate holdings to balance their portfolios when the equity markets fall. Real estate has always been a lagging indicator of market sentiment and the correlation to the equity market is an extension of that idea.
Generally, rising interest rates historically lead to a recession, falling stock prices, and ultimately corresponding increasing cap rates, so the original linkage could still apply. But, that doesn't seem to be the case this time, and certainly not in industrial - yet. I would argue that in today's world, we have not seen the significant increase in cap rates that we should have by this point because the market has not corrected to match the rise in interest rates. In addition, everyone is uncertain about the labor shortage and if that will lead to more inflation, a strong economy, a recession, or even more significant interest rate rises. It is likely that we have more raises from the Fed in the future, as the effect that these raises have had on inflation and unemployment has been somewhat muted to date.
Another piece of the puzzle to consider is the structural shift in industrial leasing demand as compared to previous cycles. In built-out markets such as Los Angeles and Orange County where much of our portfolio is located, the vacancy rate still hovers around 1% with only slight signs of softening. The demand drivers of the LA & Long Beach Ports and more than 15 million local residents combined with the supply constraints of land scarcity and increasingly restrictive municipalities make the existing industrial product a safe bet. Institutional investors now look at industrial as a far safer asset than in prior cycles and therefore are devoting more capital to this asset class and putting a floor under current pricing. But do we really think industrial real estate should have such a slim risk premium over the US 10-year treasury, which stands at 3.38% as I write?
Moreover, the national industrial real estate cap rate spread over BBB bonds has historically been 250 bps. The iShares BBB Rated Corporate Bond ETF’s Average Yield to Maturity is 5.26%. If anyone reading has 7.75% cap rate deals, please send them our way!
Of course, this is from my perspective based on the industrial world. I am sure an investor holding office or retail might have a different view.