Are Cap Rates and Interest Rates Correlated?
With interest rates at near all-time lows, and inflation starting to show in some parts of the economy, it is likely that rates will rise at some point in the next several years. This has caused many owners to ask us how closely are cap rates and interest rates correlated and how will it affect the value of my senior living communities in the future.
The interest rate on a US Treasury Bond is considered the “risk free” rate of return since the United States Government has never defaulted on its treasury bonds, it is the world’s trade currency, and the United States has the ability, through the Federal Reserve, to print money to meet its obligations. Therefore, many investments are analyzed by their spread over the US Treasury rate. The riskier the asset, the larger the spread is over the US Treasury. Over the past 10 years, skilled nursing cap rates have averaged about 900-1,100 basis points above the US 10-year treasury rate and assisted living cap rates have averaged between 400-600 basis points above the US 10-year treasury rate. This is because skilled nursing is considered a riskier asset than assisted living.
Why are Cap Rates and Interest Rates Correlated
This raises the question, is the risk “spread” over the US Treasury a constant or not? Or, when interest rates change, do cap rates always change in exact correlation? Although interest rates and cap rates are closely correlated, there is not a 100% correlation.
The risk premium over the “risk free” rate of a US Treasury Bond of any asset is going to vary based upon the demand of investors. If the given asset suddenly becomes more attractive to investors, the risk premium will decrease, and vice versa. The risk premium also varies based upon future expectations of a given asset. Seniors housing assets still have a greater risk premium than traditional market rate apartments since the investment community considers it a riskier asset. However, given the future demand for seniors housing, this risk premium may decrease, resulting in a lower cap rate.
While interest rates do have a strong correlation with cap rates, there are many other factors that go into determining a cap rate, most importantly, the future risk that investors perceive in a given asset. Thus, in a rising interest rate environment, we can expect cap rates to increase. However, based upon investor demand and risk premium, the correlation will not be exact.