Santa Ana, California .– (Business Wire) –First American Financial Corporation (NYSE: FAF), A leading provider of title, settlement and risk solutions for real estate transactions and a leader in the digital transformation of its industry, today released First American Proprietary’s Potential Capitalization Rate (PCR) model for the first quarter of 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 lending in the economy, and recent property price trends.
Commercial Real Estate Economist Analysis: Peak Rates Near All-Time Lows in First Quarter 2022
“When inflation first started to rise in 2021, many believed it would be temporary. Inflation remained stubbornly high, however, prompting the Federal Reserve to tighten monetary policy. In response, the yield on the 10-year Treasury note doubled from 1.5 percent at the end of last year to about 3.5 percent in mid-June,” he said. Xander Snyder, senior commercial real estate economist at First American, said: “The Fed will increase the federal funds rate, Indirectly affects long-term yields such as the 10-year Treasury note, which began in May this year. However, quantitative tightening, the Fed’s other tool for tightening monetary policy, directly affects the 10-year Treasury bond. The Fed began quantitative tightening in June and is expected to continue quantitative tightening in the coming months, so the yield on the 10-year Treasury is expected to rise further.
“Investors typically view the interest rate paid on the 10-year Treasury note as ‘risk-free,’ so when considering investments with higher risk they typically seek a higher return than the 10-year Treasury yield,” Snyder said. “Since capitalization (cap) rates are a measure of the return on assets, high ‘risk-free’ rates mean sellers need to lower their price expectations or increase cash flow, if that’s an option, and cap rates should also be raised to entice buyers seeking competitive yields.
“So far, this has not happened. Cap rates remain at all-time lows and commercial real estate (CRE) price growth remained relatively robust in the first quarter, albeit slower than the record growth seen in the fourth quarter of last year,” Snyder said. “However, interest rates rose dramatically in the second quarter and We know that the Fed’s efforts to fight inflation may continue to increase. So, how will rising interest rates affect cap rates over the rest of the year?
Slower CRE price growth is likely to drive up cap rates
“The first American PCR model suggests that while interest rates influence cap rates, recent CRE asset price growth is a more significant driver,” Snyder said. “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 fell to 4.3 percent, roughly 1 percent below the actual national cap rate of 5.3 percent.
“In the first quarter, however, national CRE price growth slowed on a quarter-over-quarter basis and potential cap rates are expected to increase. According to the PCR model, a moderation in quarterly price growth in the first quarter leads to a modest increase in the potential cap rate in the second quarter, suggesting that actual cap rates will follow, Snyder said. “As shown in this chart, higher interest rates led to an increase in the potential cap rate, but upward pressure from slower CRE price growth was a more significant contributor to the increase in the second quarter potential cap rate.”
Back to normal
“It’s worth noting that the drag on CRE price growth is not evenly distributed across asset classes,” Snyder said. “Multifamily and industrial assets set first-quarter price growth records, increasing at the fastest rate of any first quarter in the past 20 years, while office and retail assets were a drag on overall CRE price growth in the first quarter. However, record amounts of industrial square footage are currently under construction and this year Expected to hit the market later, this could slow industrial asset price growth and put further pressure on the potential cap rate as the year progresses.
“Interest rates are higher today than they were a year ago and are now close to mid-2018 levels. Yet, despite a comparable interest rate environment in 2018, commercial transaction volume increased by nearly 16 percent from the first quarter to the fourth quarter of that year. In other words, demand for commercial property grew throughout 2018 despite a similarly challenging interest rate environment. Looking ahead, cap rates are seen moving upwards as investors change their risk tolerance. However, more moderate CRE price growth reflects a shift to a new normal rather than significant industry disruption.
First quarter 2022 potential cap rate
Nationally, the potential cap rate is 4.3 percent, a decrease of 0.2 percentage points compared to the fourth quarter of 2021.
The potential cap rate is down by 0.4 percentage points compared to a year ago.
Currently, the potential cap rate is at its lowest level in 20 years, 4.6 percentage points above its third-quarter 2001 peak of 8.9 percent.
Cap rate outlook gap
In the first quarter of 2022, the national actual cap rate was 1.0 percentage points higher than the potential cap rate. However, given the decelerating price growth and upward movement of interest rates in the first quarter, the potential cap rate is expected to increase in the second quarter.
The gap between the actual cap rate and the potential cap rate widened by 0.4 percentage points between the fourth quarter of 2021 and the first quarter of 2022.
The PCR model is updated quarterly with new data. Look for the next version of the PCR model in the third quarter of 2022.
About the potential cap rate model
The potential cap rate (PCR) model estimates cap 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 PCR model uses these metrics to establish potential cap rate levels that support these market fundamentals. If actual cap rates are significantly higher than potential cap rates, there is a greater chance that actual cap rates will fall. Conversely, when actual cap rates are significantly below the basic cap rate level, there is a greater chance that actual cap rates will increase. Potential cap rates are aggregated nationally and include all major property classes: multifamily, retail, industrial, office and residential. PCR pattern is updated quarterly.
A cap rate is a measure of estimated yield or return, assuming no debt is used to purchase the investment property. Cap rates are calculated by dividing a property’s net operating income (NOI) by its value. NOI is the property owner’s residual income after meeting operating expenses, but before meeting debt. Because cap rates do not take debt service into account, cap rates are a measure of the so-called arbitrary yield.
The opinions, estimates, forecasts and other views contained on this page are those of First American’s Office of the Chief Economist, do not necessarily represent the views of First American or its management, should not be construed as indicative of First American’s business prospects or expected results, and are subject to change without notice. Although the First American Economics Team endeavors to provide reliable, useful information, it does not guarantee that the information is accurate, current or appropriate for any particular purpose. © 2022 by the First American. The information on this page can be used with the right attribute.
About the First American
First American Financial Corporation (NYSE: FAF) A prime provider of title, settlement and risk solutions for real estate transactions. With a combination of financial strength and stability, innovative proprietary technologies and unmatched data assets built over 130 years, the company is leading the digital transformation of its industry. The First American Title provides data products to the industry and other third parties; Evaluation products and services; Mortgage Subsidiary; Home warranty products; Banking, trust and wealth management services; And other related products and services. With a total revenue of $ 9.2 billion in 2021, the company delivers its products and services directly and through its agents in the United States and abroad. In 2022, First American was named one of the 100 Best Companies to Work For by Great Place to Work® And Good luck This is the seventh consecutive year that the magazine has. More information about the company can be found here www.firstam.com.