• Just like bonds have enjoyed an extended bull market supported by a long-term decline in interest rates, equity commercial real estate (CRE) has experienced its own such growth as capitalization (cap) rates also have seen a substantial decline.
  • Cap rates reflect an investor’s return based on the property’s net operating income (cash flow) and the property value.
  • Similar to bond yields and prices, cap rates have an inverse relationship with property prices. Therefore, as cap rates have fallen over the past several decades, property values have seen significant appreciation.
  • As the chart highlights, cap rates of office properties trended lower from approximately 1995 through 2015, leading to substantial total returns for CRE equity investors.
  • Since 2014, however, there has been a shift. Rent growth has remained generally stable, but real interest rates have been range-bound, causing cap rates to follow suit. Using office properties as an example, from 2015–2018, price growth averaged 4.7% per year, nearly all of which was driven by rent growth.
  • We believe the takeaway is not that cap rates are bound to expand, but that given historically low cap rates, income may serve as a larger component of price growth.

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