Loan Spreads & Implications on CRE

Trepp’s December 2018 analysis entitled “It’s All About Rates” has a lot to say about where the CRE market could be headed if analyzed from a risk-free rate and loan spread perspective. An interesting data point put forth by Trepp is that “loan spreads have generally averaged about 150 basis points when the 10-year was above 4% and around 250 basis points when the 10-year was below 4%.” We have already seen agency lenders’ spreads compress in the face of a rising treasury but recently widen due to some volatility. However, this statistic means that lenders’ spreads could remain compressed as T bonds rise. Next, the report argues, “If we assume the 10-year gets back to 4% in the next year or so and that loan spreads end up around 200 basis points, average CRE loan rates should climb to 6%.” This would put a ton of pressure on cap rates (historically cap rates have been 200 basis points above the cost of debt). I think the known demands for multifamily real estate as well as the increase in allocation from the world’s pools of capital has caused a secular, downward trend on cap rates. Basically, I think the average difference between cap rates and cost of debt moving forward will be closer to 100 basis points.

However, Trepp’s report runs with the aforementioned historical spreads to conclude that the anticipated rise in interest rates “would put average cap rates at 8%, up from 6.5% in the most recent quarter. A move of that degree in cap rates, assuming NOI remains constant, would send values down by 18.75%.” A nearly 20% correction in CRE prices would be a major shock and I don’t think anyone is predicting anything that extreme within the next few years. To counter, the 10 year US treasury is a reflection of inflation expectations and inflation would drive NOI growth, helping to offset cap rate expansion.

Lastly, Trepp argues that “the margin for error on higher value properties is smaller. For example, a 1% increase in a 4% cap rate property has a much larger negative value effect (-25% where as a 1% cap rate increase on a 8% cap rate property (-11.11%).” While this point bolsters the thesis to invest in higher cap rate, affordable housing (class B/C in secondary/tertiary markets) versus class A in gateway markets, I would counter that higher quality geographies and assets will be more liquid and resilient in the face of an adverse credit market.

Reference: Trepp December 2018 CRE Research