As interest rates continue to rise, many investors are worried about the effect these rates will have on their cap rates. Lon Welsh, founder of Your Castle Real Estate and Ironton Capital is back to explain the relationship between these concepts and review the historical data.
- Watch the YouTube video (at the bottom.)
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the video.
Historic Review of Bear Markets
Since the Great Depression, there have been 14 bear markets. A bear market occurs when the stock market declines by 20% or more. He looked at each one and analyzed what caused the crash, when it started and finished, and drawdown, or how much the stock market corrected.
In this chart, the red circles indicate times the market continued to drop after its initial 20% drop. There’s about a 50/50 chance that the stock market will continue to decline after that drop. Usually, these drops occurred during a recession. When we eliminate the non-recession drops, we see that there’ s a slightly worse chance that the market will continue to go down.
What’s the 10-Year Treasury Yield, and Why Does It Matter?
The most popular method of borrowing money for the US government is the 10-year treasury yield. These are generally seen as a safe investment because they’re backed by the US government, and tend to be viewed the safest investment available.
If you look at 2020, right before Covid started, you can see the interest rate was at 2%. Then there was a huge decline as the government tried to stimulate the economy, and then interest rates went back up. Today, they’re tracking a little below 3%.
When we talk about interest rates going up 2.5% in a short period of time, it’s important to realize that 1.5% of that amount comes from recovering from covid. In effect, it’s really a 1% increase in rates.
Looking back to July 2018, the rate was about 3%, which is almost exactly what it is currently. We haven’t been in a really low rate environment for the past 30 years, but that the low rates we had were fairly short-lived.
Cap Rates and the 10-Year Treasury Yield
Over the past 40 years, the dashed blue line is the 10-year treasury rate and the orange line is the cap rate. For the earlier years, this data blends together all commercial assets, and the more recent data specifically looks at multifamily information.
The overall trend over the past 40 years is interest rates and cap rates both going down. However, there’s not a lot of correlation between the two.
There have been nine times that the interest rates spiked up by at least 1% in a short period of time. What was the effect on cap rates during that time? In 1981, when the interest rate went up 1.9%, the cap rate dropped by 0.3%. In 1982, the interest rate spiked 1.8% and cap rates again dropped.
Over the last 40 years, when the interest rate spiked by more than 1%, cap rates dropped by an average of 0.1%, an amount so small it’s not statistically significant.
When we look at times the interest rate dropped by 1% or more, cap rates again only changed 0.1%. This shows that interest rates and cap rates are not correlated; they’re entirely different markets.
So, when we look at 2022 with interest rates up 2%, we see that cap rates are unchanged. In the past few years, interest rates have gone up and down, but cap rates are not affected.
How Does This Data Compare to the Big Picture?
In other countries, especially those that have almost no more land to build on (e.g., Japan), cap rates can be as low as 1-2%. There’s no supply, so cap rates are low no matter what the economy does. We should remember that cap rates can always go lower in America, and our data shows that they keep drifting down.
In 2019, when interest rates were where they are currently, the cap rate was a tenth of a percent higher. Also keep in mind that every time interest rates spike, they tend to drop the next year. We also usually see a rise in interest rates right before a recession, but that’s a topic for another episode.
How Can I Strategize for the Future?
One strategy to look into is putting an Adjustable-Rate Mortgage on new properties in anticipation of rates dropping during a recession. Then, you’ll be able to refinance into a better rate.
When we look at 20-year returns by different income vs assets, we can see just how real estate performs.
Household income hasn’t changed much. The S&P went up 150%-180%, which is pretty respectable. Home equity without leverage performed worse than the S&P.
For a typical person who put 20% down on a home, however, equity is in the 700% range. In effect, real estate blows the doors off the stock market.
We often talk about how real estate is a great investment, but it’s really the leverage aspect that makes the biggest difference. Leverage is key when it comes to real estate.
Learn More about the Market
If you have any questions about this data, reach out to us with your questions.