How Closely are Cap Rates and Interest Rates Correlated?

A cap rate is calculated by dividing the net operating income of a property by the purchase price.   The cap rate would equal the rate of return on equity if a property was bought with all cash and the net operating income stayed the same for the next twelve months.    As cap rates increase, the purchase price decreases, and vice versa.  

The interest rate on a US Treasury Bond is considered the “risk free” rate of return, since US Government has never defaulted in the past, it is the World’s trade currency, and it 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 1,000 basis points above the US 10 year treasury rate and assisted living cap rates have averaged about 600 basis points above the US 10 year treasury rate.   This is because skilled nursing is considered a riskier asset than assisted living.

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 connected, there is not a 100% correlation. 

However, inherently, 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.   Additionally, the risk premium 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 more risky asset.  However, given the future demand for seniors housing, this risk premium may decrease, resulting in a lower cap rate, even if interest rates increase.  Thus, while interest rates do have a strong correlation with cap rates, there are many other factors that go into determining a cap rate, mostly importantly, the future risk that investors perceive in a given asset.

For more information about Senior Living asset values, please contact Jason Punzel, Senior Associate, at Senior Living Investment Brokerage, INC.  punzel@slibinc.com.