Cap Rates and Capital Market Expectations

CFA Level III
#1

can someone pls simplify this below paragraph?

“Cap rates reflect long-term discount rates. As such, we should expect them to rise and fall with the general level of long-term interest rates, which tends to make them pro-cyclical. However, they are also sensitive to credit spreads and the availability of credit. Peyton (2009) found that the spread between cap rates and the 10-year Treasury yield is positively related to the option-adjusted spread on three- to five-year B-rated corporate bonds and negatively related to ratios of household and non-financial-sector debt to GDP. The countercyclical nature of credit spreads mitigates the cyclicality of cap rates. The debt ratios are effectively proxies for the availability of debt financing for leveraged investment in real estate.”

#2

If you think of the Gordon growth model:

V_0 = \frac{CF_1}{r - g}

the denominator – \left(r - g\right) – is the cap rate.

Assuming the growth rate of the cash flows doesn’t change, then the cap rate changes as the required return changes. So . . . what makes required rates of return change?

As the general level of interest rates changes, so goes the required rate of return, so goes the cap rate. But as credit spreads change, so do required rates of return (we’re not talking about risk-free investments here), so cap rates also change. Because credit spreads tend to move opposite the general level of interest rates, and by a smaller amount, their movement tends to mute the movement of cap rates. They tend to follow general interest rates, but change by smaller amounts.

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#3

let me see if I understood the meaning

  1. cap rate = k-g. Assuming g is constant, if k goes up, so does cap rate. Ok got this point
  2. household debt/GDP and cap rate- so assuming for this one that higher rate, lower the amount of debt people will take because of the higher interest payments, hence why they are negatively related ( pls correct me if I am wrong)
  3. i don’t think I’m getting the relationship between the cap rates and credit spreads
#4

  1. Perfect.

  2. Sounds right to me.

  3. Real estate is a risky investment, so you should expect the required rate of return to follow the pattern of the required return on risky bonds: risk-free rate plus credit spread. All else equal, as credit spreads increase, cap rates increase; as credit spreads decrease, cap rates decrease.

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#5

gotcha! thank you

#6

My pleasure.