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Cap Rates Expected to Rise as Asset Growth Slows

First American Financial Corporation’s [1] Potential Capitalization Rate (PCR) for Q1 2022 came in 1 percentage point higher than its potential cap rate of 4.3% and is expected to increase in Q2 due to decelerating price growth in the first quarter and continued upward movement of interest rates.

The gap between the actual cap rate and potential cap rate increased 0.4 percentage points between Q4 20201 and Q1 2022.

The PCR model estimates capitalization rates based on the historical relationship between interest rates, rental income, prevailing occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends.

The potential cap rate is at its lowest level in more than 20 years, 4.6 percentage points below its third quarter 2001 peak of 8.9%.

“When inflation first began to surge in 2021, many believed it would be transitory. Inflation has remained stubbornly high, however, prompting the Federal Reserve to tighten monetary policy. In response, the yield on the 10-year Treasury note has more than doubled, from 1.5% at the end of last year to nearly 3.5 percent in mid-June,” said Xander Snyder, Senior Commercial Real Estate Economist at First American. “The Fed’s increases to the federal funds rate, which began in May this year, indirectly impact longer-term yields, such as the 10-year Treasury note. However, quantitative tightening, the Fed’s other tool to tighten monetary policy, will directly impact the 10-year Treasury bond. The Fed began quantitative tightening in June and is expected to continue quantitative tightening in the months ahead, so the yield on the 10-year Treasury is therefore expected to increase further.”

As inflation increased to 9.1% in June 2022, the Federal Reserve decided to raise [2] the nominal interest rate by 75 basis points from a range of 1.50-1.75% to a current rate of 2.25-2.50%. 

This marks the fourth increase this year and the biggest consecutive rate hike on record. So far this year, the Federal Reserve raised rates in March (+25 points), May (+50 points), and June (+75 points). 

First American’s PCR model suggests that, while interest rates influence cap rates, recent CRE property price growth is a more significant driver.

“For example, in the first quarter of 2022, interest rates put upward pressure on the potential cap rate, but the downward pressure from record price growth in the previous quarter was much greater, so the potential cap rate declined to 4.3%, approximately 1% below the actual national cap rate of 5.3%,” Snyder said.