The Persistence of Low Capitalization Rates

Ever since the Federal Reserve Board began raising interest rates approximately two years ago, there has been a general expectation in the real estate market that capitalization rates would begin to rise also, forcing a decline in real estate prices. Although the Fed Funds rate has been raised incrementally over the past two years from 1% to its current level of 5%, there has been no discernable effect on pricing in the real estate market. In fact, it is our belief that prices have materially strengthened during this period.

Two years ago, at the time of Falcon's Third Quarter 2004 newsletter, the Fed Funds rate was still at the 1% level and at that time we suggested three reasons why real estate prices were unlikely to decline in the immediate future, despite any increase in interest rates. We expressed the belief that mortgage rates would not rise significantly in the short term; we predicted that demand for real estate would remain strong; and we pointed to the positive trends in the real estate market itself, including rising occupancy rates and increasing rental rates. All of these events have occurred, although some of them have persisted longer than we had anticipated.

In addition to the factors mentioned two years ago, several other factors have contributed to the persistence of low capitalization rates. One of the most important of these has been the surprising action of the bond market, which has moved to an inverted yield curve, and the implications that this has for investors’ long-term yield expectations. In addition, real estate, being a real asset, has frequently been looked upon as an inflation hedge in the past, and with inflation again becoming a growing concern in the U.S. economy, this has become a consideration for many investors. And finally, there is a tremendous amount of liquidity in the global economy and alternative investment vehicles have not appeared to be as attractive as U.S. real estate.

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Mortgage Interest Rates:

Most mortgage interest rates in the United States are set as a spread over comparable maturity U.S. Government bonds. Two years ago, when the Fed Funds rate was at 1%, the 5-year maturity U.S. Government bond was yielding 3.9% - the yield having risen through the first half of the year in anticipation of the Fed's action. But while basic interest rates have risen during the past two years with the 5-year Government bond now at 5%, the spreads being charged by most mortgage lenders have declined. These spreads were in a range of between 200 to 250 basis points over comparable maturity Government bonds in 2004, but this has narrowed to about 100 basis points or even less today. As a result, mortgage money remains available at historically attractive rates, and it has not yet been the negative on the real estate market that had been anticipated.

The Inverted Yield Curve:

While yields on shorter-maturity U.S. Government bonds have been rising since the beginning of 2004, yields on bonds with 10-year maturities or longer have been flat to declining. This clearly indicates that long-term investors have been willing to accept returns that are either lower or, at best, no higher than returns available on shorter-maturity securities. The usual explanation for an inverted yield curve is that short-term rates have been increased in an attempt to contain inflation, while long-term rates have declined in anticipation of the lower interest rates that will accompany a business recession. In the present situation, it is clear that the Federal Reserve has been increasing short-term rates to prevent inflationary pressures from building up, but the low level of long-term rates is probably more a reflection of excess global liquidity, rather than any significant concern about a recession. Real estate, of course, has to be looked upon as a long-term investment, and with many long-term investors willing to purchase Government bonds with ten, twenty and thirty year maturities all currently yielding approximately 5%, it is perhaps not surprising that capitalization rates, or yields, in the real estate market are also approaching the 5% level.

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