A roller coaster ride of cap rates in the U.S. economy by Rynne

February 07, 2017 - Upstate New York
John Rynne, <a class=Rynne, Murphy & Associates, Inc." width="240" height="300" /> John Rynne, Rynne, Murphy & Associates, Inc.

Over the past number of decades interest rates have been on a roller coaster ride. As a result, overall capitalization rates (cap rates) also have been a passenger at a slow motion level. Although cap rates tend to move in the same general direction as mortgage interest rates, the movement is muted. Over the past few years overall capitalization rates (cap rates) have been at the lowest levels in my 42 years as a real estate appraiser. Even in the mid 1980s as a result of the Economic Recovery Tax Act (ERTA) of 1981, the rates were not that low even though the rate of decrease was more significant. The reason this time period (1981-1986) was significant in regards to cap rates was the rate of decrease from 1981 to 1986 was the largest in history. This was due to two factors:

1) The huge reduction in mortgage interest rates and

2) The almost “overnight” substantial decrease in tax rates on real estate income such as lower capital gains, massive acceleration depreciation benefits, some enactment of income tax credits, etc.

The mortgage interest rates in the late 1970s and early 1980s were approaching as high as 17-18%. By the mid 1980s mortgage interest rates declined massively. With the combination of the benefits of ERTA there was a massive decrease in cap rates over a 3-5 year period as high as 400-500 basis points because in the late 1970’s and early 1980s cap rates were at some of the highest levels in modern history. Thus, the cap rates had much farther to fall than the more recent 2016 and the current 2017 market compared to where cap rates were in 2009. As a side note, the Tax Reform Act (TRA) of 1986 resulted in a reversal of low cap rates with the reduction of depreciation and other real estate benefits; so the slow motion roller coaster continued. Cap rates also were at a relatively low level during 2004-2007 but not as low as the 2016 cap rates. The 2004-2007 cap rate reductions coincided with the Bush tax cuts and the intervention by the Federal Reserve Bank. So the roller coaster ride also continued during that time period.

The ineffective fiscal policies of the Obama administration resulted in the slowest gross domestic product (GDP) growth in history following a recession in spite of the largest increase in the national debt in history. The national debt is approaching $20 trillion which represents over a 90% increase over the $10+ trillion in 2008. Because of the low GDP growth, the Federal Reserve under Ben Bernanke started monetary policy measures to keep interest rates low which resulted in “inexpensive” money for consumer spending, business expansion, etc. Bernanke’s replacement, Janet Yellen, doubled downed on the monetary policy of quantitative easing. The overall result since 2007 was the balance sheet of the Federal Reserve increasing by almost 400% due in part the purchasing of various U.S. government paper such as U.S. treasuries, etc. In effect, interest rates were being artificially kept low to encourage consumer spending, business investment and expansion with very mediocre nominal growth at a high expense. Although the Federal Reserve is a form of an independent bank, it is still a quasi governmental agency. This tactic smacks of a shell game; by moving government assets/debt from one entity to another to disguise the problem.

Recently, the Federal Reserve has increased rates which has put substantial pressure on mortgage rates and ultimately cap rates. In part before this, Janet Yellen wanted to maintain low interest rates as long as possible to prop up the Obama Administration legacy. After all, Yellen was an appointee of President Obama and President-elect Trump was very critical of her during the presidential campaign. As a non-political reason for a rate increase by the Federal Reserve, President-elect Trump is planning a fiscal strategy of across the board tax cuts for 2017 in order to put more resources in the hands of the private sector. This should create substantial GDP increases and some inflation pressure; so there is some justification for the Federal Reserve actions. Thus, late in the 4th quarter of 2016 was a significant increase in commercial mortgage interest rates as high as 70-100 basis points. This has a substantial upward effect on cap rates. Thus, the slow motion roller coaster continues; stay tuned!

John Rynne, MAI, SRA is the president and owner of Rynne, Murphy & Associates, Inc., Rochester, N.Y.

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