By Tad Philipp, Managing Director, and Sally Gordon, Vice President, Moody's Investors Service

Capitalization rates play an extremely important role in commercial real estate credit. The cap rate - akin to a building's P/E ratio - drives the loan-to-value ratio (LTV), one of the two key loan level credit tests.

Low cap rates have been pushing up property valuations, but the apparent disconnect between real estate cash flows and property values is an issue for credit in CMBS. Both cap rates and commercial mortgage rates are at historically low levels. If either or both were to rise within the term of today's mortgages backing CMBS, the risk increases that borrowers would have difficulty refinancing their mortgages at the end of the term, and the balloon risk in CMBS correspondingly escalates.

In the current market, cyclical issues (such as historically low interest rates) outweigh secular trends (such as increased liquidity in commercial real estate). Acknowledging that real estate as an asset has changed significantly due to the incursion of the capital markets, we nonetheless remain skeptical of wholesale "paradigm shifts." We believe that cap rates are likely to rise from current levels within the terms of most loans, although not to the levels of the early 1990s.

Cap Rates Are Extremely Low By Any Measure

The cap rate is merely the relationship between a property's income and value. The lower the cap rate, the higher the valuation of a given level of cash flow. The cap rate thus provides a shorthand for investors' expectations of yield and assessment of risk at any point in time.

Cap rates are currently at the lowest levels since the 1960s, both in absolute and relative terms (see figure 1). The composite cap rate, now at 8.8%, has dropped below 9% only a few times since 1965. Furthermore, the spread between cap rates and 10-year U.S. Treasuries, typically about 200 to 250 basis points, now has widened to over 450 basis points, an all-time record gap. That current spread is unmatched since the late 1960s and early 1970s, when interest rates were also at sub-six levels, as they are now. (Cap rates are from the American Council of Life Insurers; data are through third quarter 2002.)

Disconnect Between Cap Rates and Market Fundamentals

Curiously, the downward drift in cap rates comes at a time when property market fundamentals are weaker than a few years ago. A drop in cap rates should accompany reduced risk but instead has coincided with weak property fundamentals. For example, office cap rates have been notably "sticky," even as vacancy rates have risen above 16%. Anecdotal evidence of firm prices is accumulating - in the face of soft and softening cash flows. Furthermore, leases that roll over in the next one-two years might well be re-leased at lower rent levels, creating further drag on revenues in the near term.

Commercial mortgage rates have dropped to 6%, according to the JB Levy Commercial Mortgage Survey. Today's low mortgage rates are also well below cap rates - in fact, by the widest spread in nearly 20 years. The combination of low commercial mortgage rates and the positive leverage of interest rates below cap rates are what we believe to be the primary driver of low cap rates. This is in stark contrast with the negative leverage that prevailed in the late 1980s, when cap rates were running 100 basis points less than commercial mortgage rates.

A Shorthand for Assessment of Risk

Cap rates serve many purposes from the point of view of either equity or debt. However, from Moody's vantage point, cap rates relate to the perception of risk.

But all risk is relative. In the last few years, with an equity market that has been struggling and a bond market that has offered the dubious combination of low yields and higher corporate credit risk, capital has been flowing into commercial real estate. The perception of commercial real estate securities as a "safe haven" is fueled by many factors: Yields on alternative investments range from disappointing to downright dreadful, and real estate, particularly CMBS, appears to be less volatile and more transparent than many other investments.

Nevertheless, as the economy recovers, and if equity markets rise with that recovery, some of the capital that has sought haven in real estate is just as likely to return to other investment options. Capital is imminently portable - and sometimes exceedingly nimble. Just as capital flowing to the asset class can put upward pressure on prices of the underlying real estate, capital flowing away from the asset can undermine prices.

Cyclical and Secular Drivers of Cap Rates

Like many financial variables, cap rates are driven by both cyclical and secular factors. The cyclical aspects can be unwound or reversed as we move through different phases of the business cycle. Secular variables take into account underlying differences between this cycle and any previous ones and focus on fundamental shifts in the dynamics of a market.

The cyclical factors that are driving down cap rates all speak to a greater probability that cap rates will rise rather than be sustainable at current levels. Interest rates and commercial mortgage rates at historically low levels are more likely to rise from here than fall further. Also, wider spreads are principally because asset-specific rates (either mortgage rates or cap rates) tend to be stickier than macro-level interest rates. As a result, interest rates could rise some from current levels, thus narrowing the spread between mortgage rates or cap rates and Treasuries, before pushing up asset-specific rates.

The lags between economic weakness and demand for commercial real estate are such that real estate did not begin to suffer immediately upon the first quarter of negative GDP growth. Instead, many properties are insulated by lease terms, and cash flow might not be impaired until existing leases roll over, when space is re-leased at lower market rent levels. Thus the cash flow impact of slower demand has yet to work its way through the system. As a result, even if the macro-economy were to experience a miracle cure for all that ails it, real estate cash flows are likely to continue to decline - and cap rates should rise to reflect that.

To the extent that cap rates rise, borrowers need cash flow growth to maintain re-financable leverage. A certain level of rent growth is necessary just to keep up with the increase in expenses, which could plausibly grow slightly more than inflation, given rising costs for insurance and local real estate taxes. However, for many properties in the near term, any but the most modest revenue growth seems a reach. And if market rents remain flat or fall in the next couple of years, the growth rate in the remaining term of the loan must be even higher to compensate.

Role of Cap Rates in CMBS Credit

A low cap rate neutralizes the disciplinary effectiveness of the "V" in the LTV by inflating that value and thereby making a loan appear to be more conservative than might be merited. However, if cap rates rise, credit-worthiness would be threatened and refinance risk would increase.

If loans are refinanced into a cap rate environment higher than today's, then the ability of the borrower to take out enough capital to retire the existing mortgage could be eroded. Cap rates hovering 1% below their norm might not seem like a lot, but for CMBS that is enough to influence the value component of LTV by about 10% ... and that, in turn, is enough for credit to potentially be off by a full rating grade or more.

An increase of either mortgage rates or cap rates from current levels could be challenging to borrowers. Increases in both - from virtually all-time lows - could materially affect the refinance risk of CMBS bonds.

Where Do Cap Rates Go From Here?

Are cap rates poised for an upward adjustment? They were probably too high (1979 to1983), too low (now?), and could return to a level that is just about right.

In the long term, we expect cap rates to generally align with fundamentals although, from time to time, as in the present case, there can be disconnects due to interest rates or the property sales market. As a result, cap rates are likely to rise from current levels within the near term. However, given some important secular trends, such as increased liquidity and information, we do not expect cap rates to return to the levels of the early 1990s.

This is an excerpt from a report of the same name; it is available on www.moodys.com.

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