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The REconomy Podcast™: How Will Rising Interest Rates Impact Commercial Real Estate Cap Rates?

In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss how rising interest rates may impact commercial real estate cap rates using their proprietary Potential Cap Rate Model.Don’t miss a single REconomy episode, subscribe today.

Listen to the REconomy Podcast Episode 41:


“There are clear differences by commercial asset class, regardless of broader underlying rate environments. As Odeta pointed out, industrial, particularly driven by online retail, and multifamily, young millennial demand, are both benefiting from strong demand relative to supply. Offices and hotels, on the other hand, are requiring higher returns because of all of that future uncertainty.” – Mark Fleming, chief economist at First American


Odeta Kushi - Hello, and welcome to episode 41 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark. Today, we're gonna talk about a part of real estate that we don't usually address, but makes up a huge part of our lives. Every time you walk into a Starbucks or get a delivery from Amazon, you're interacting with this part of real estate.

Mark Fleming - Hi Odeta. That means we're talking commercial real estate today.

Odeta Kushi - We sure are, and let's just define commercial real estate. In simple terms, commercial real estate is real estate intended to generate a profit. Contrast that with residential real estate, what we're usually talking about, which is defined as real estate meant for people to live in. Commercial real estate has many different asset classes, as we like to call it. Retail. That's your Starbucks. Industrial. That's warehouses and logistics centers. Office space. I think that's pretty self explanatory. And hospitality, which is hotels.

Mark Fleming - And also multifamily, like apartments.

Odeta Kushi - Right. And the reason we're talking about this today is because the rising interest rate environment we're currently experiencing due to the Fed's attempts to reduce inflation impacts commercial real estate.

Mark Fleming - That's right. And we came up with a model, because that's what economists do, we come up with models to try to better understand just how rising rates may impact commercial real estate. It's called our Potential Cap Rate Model, or PCR Model. That is not to be confused with the PCR tests we've all become so familiar with in the recent years.

Odeta Kushi - Mark, Potential cap rate? We're talking about real estate, not hats.

Mark Fleming - Haha, that's a good one. But guess what? It's gonna get better? No, cap rate stands for capitalization rate, not the hat you wear. Okay, watch out listener. Here comes a little econ gon, aka econ jargon.

Odeta Kushi - Uhh, eye roll, my goodness.

Mark Fleming - Okay, fair, fair. Okay, I'll stop the jokes. A cap rate is the estimated yield, or the return, on an investment property assuming no debt is used to purchase it. Cap rates are calculated by dividing an asset's net operating income (NOI), sort of the profit, by its value. NOI is that income leftover to an owner after covering operating expenses, but before servicing debt. Since cap rates do not take into account debt servicing, sort of a loan that you might get to buy the real estate in consideration, cap rates are a measure of what is called unlevered yield.

Odeta Kushi - So holding that NOI constant, an increase in prices would result in a lower cap rate and vice versa.

Mark Fleming - That's right. Typically, a lower cap rate means an investment is less risky, because investors are willing to accept lower income returns relative to the price because of perceived lower risk.

Odeta Kushi - That makes sense. So we've explained the cap rate part of the PCR Model. But what does the potential imply?

Mark Fleming - Yes, well think about where else we see the word potential. It shows up in economics and potential GDP in our very own proprietary Potential Home Sales Model. So, while actual describes what happens in real life -- remember, we're economists and we make models -- potential implies a level that could be achieved given market fundamentals. That is, assuming you know what those fundamentals are and can measure them.

Odeta Kushi - That's no problem. We're economists we assume all the time. So, the Potential Cap Rate Model uses different metrics to establish a potential cap rate level that is supported by market fundamentals. But what are the fundamentals in our model?

Mark Fleming - Great question. The PCR Model estimates cap rates based on the historical relationship between interest rates -- what we were just talking about -- rental income, prevailing occupancy rates -- obviously, sort of that demand for the profit-generating capability -- and the amount of commercial mortgage debt in the economy. We include that to sort of get a sense for how much demand is out there to buy commercial real estate. And also, likewise, a measure of the supply and demand dynamic are the recent property price trends. This particular model is a national cap rate model, including all major asset classes, so we're able to disentangle what's driving that overall cap rate level in any given quarter.

Odeta Kushi - And what are the implications of when the PCR is above or below the actual cap rate? In our inaugural report, the PCR was below the actual, I mean, what does that mean?

Mark Fleming - When the actual cap rate is significantly above the potential cap rate, there's a greater chance that the actual real cap rate in the real world will decline because the model is saying that the actual cap rate is above what the markets "fundamentally" supports, as measured by that potential cap rate. Conversely, when actual cap rates are significantly below that potential cap rate level, there's a greater chance that cap rates will increase. Actual is below what is supported by the market. Odeta, we recently released our Q1 2022 PCR Model report. What were the findings?

Odeta Kushi - Great question. By the way, that blog post can be found on our Economic Center blog at So, in the first quarter of 2022, the national actual cap rate was one percentage point higher than the potential cap rate. So, the market could support even lower cap rates than reported, given market fundamentals. But, I think the more interesting story is where cap rates are headed and what's taking them there, particularly in this rising interest rate environment. You know, the Federal Reserve recently hiked interest rates by a more-than-expected 75 basis points in June. And, with more rate hikes to come, how does Fed tightening impact cap rates?

Mark Fleming - That's right. This is why we build these models to try and understand and answer these kinds of questions. All that Fed tightening -- increasing in the federal funds rate, quantitative tightening -- all of that is pushing up the yield, aka the return, on the benchmark 10-year Treasury bond. And if investor can earn the yield paid on a 10-year Treasury, which is considered risk free, it follows that they should be compensated with a higher return than that for any investment that has risk of any kind greater than the risk on the 10-year 'risk-free' Treasury rate, such as a commercial real estate asset. All else equal, the higher the 10-year Treasury, the higher the cap rate should be to reflect that you're taking risk over the risk-free rate.

Odeta Kushi - Well, that's a wonderful theory. But, so far, this hasn't been the case. Cap rates remain near all-time lows and price growth in the first quarter remained relatively robust, albeit slower than the record growth seen in the fourth quarter of last year. But, given the rapid increase in the 10-year Treasury from 2.75% at the end of May to about 3.4% as of mid-June, should we expect those cap rates to rise?

Mark Fleming - Well, the short answer here is yes, but we can use this PCR Model to explain it better. Remember, back to that, all else equal comment. Our PCR Model suggests that, while rising interest rates do play a role in driving cap rates up, they do not have as large an impact on cap rates as recent property price growth does. While the two are related, there are also other factors that impact price growth in addition to interest rates. For example, if investors expect prices to continue increasing rapidly, they would be willing to pay a little bit more to purchase a property now to capture the gains from price growth in the future which, in turn, drives cap rates down. Remember, the cap rate is NOI divided by price. Using the PCR Model, we can get a sense for which of the market fundamentals are most substantially contributing to changes in the overall cap rate, a decomposition, if you will.

Odeta Kushi - And in our latest report, we found something interesting. And, by the way, we include a decomposition chart in that blog post, so check that out. In the first quarter of 2022, rising interest rates contributed positively to the PCR.

Mark Fleming - Whoo. So my theory is working.

Odeta Kushi - Yes, but this upward pressure was overshadowed by record price growth from the previous quarter. This resulted in a decline in the PCR to 4.3%, which was approximately 1% below the actual national cap rate of 5.3%. So higher price growth has been keeping the downward pressure on cap rates more so than rising interest rates have put upward pressure on cap rates. But do we expect this to continue?

Mark Fleming - Spoiler alert, we do not. Although national CRE prices increased 17% year over year -- that's impressive in the first quarter -- on a quarter-over-quarter basis, price growth slowed substantially. According to the PCR, that moderation in the quarterly price growth in the first quarter will lead to a modest increase in the PCR in the second quarter. Paying more for an asset that's not expected to grow in value as much is less appealing and, therefore, cap rates should go up.

Odeta Kushi - One pretty big caveat here, not all asset classes are created equal. Decelerating price growth was not distributed evenly across asset classes. Lower price growth in the first quarter was pulled down primarily by office and retail assets. Both multifamily and industrial, on the other hand, set first quarter price growth records, increasing at a faster rate than during any other first quarter in the last 20 years.

Mark Fleming - And I want to take a second here to talk about why that is. Retail office assets face a lot of uncertainty still. We all know the primary headwinds for the office sector -- the work from home, how much of it are we going to do or not? But, there's also a lot of uncertainty about what happens to offices in a world where many are able to either work entirely from home or partially work from home. This creates uncertainty about the amount of demand, essentially, for office space and for the retail sector. Work from home is also changing where we want our retail to be. And, of course, there's the continued rise of e-commerce as an ever-present concern in the retail sector. But, one person's vinegar is another's sugar. The rise of e-commerce is the industrial tailwind. The growth in e-commerce has increased demand for warehouse and logistics centers beyond belief.

Odeta Kushi - And then there's multifamily. Driving the demand to own multifamily is the strong demand to rent apartments. We can see that demand relative to limited supply in the price growth data in April. Rents were up more than 16% on a year-over-year basis. And that demand is a result of new rental household formation from people wanting to live alone, maybe less so with roommates. And it's also driven by the fact that the for-sale market has become so unaffordable. Another reason was discussed in a recent working paper released by the National Bureau of Economic Research, which suggests that an increase in the number of remote workers during the pandemic was responsible for the majority of apartment rent growth between December 2019 and November 2021. The authors argue that the new demand for apartments is a fundamental and long-term change. Given that physical office occupancy, according to Kastle Systems data remains at 44%. The long-term change implies that there's a shortage of available apartments, due to over a decade of underbuilding and a new significant source of demand for that scarce space. A persisting supply-demand imbalance is likely to further drive price growth beyond the rate of NOI growth, and multifamily cap rates will remain low, despite increased costs of financing.

Mark Fleming - Of course, going back to our original point about the rising risk-free rate. That's just the required rate of return calculation. But there are clear differences by commercial asset class, regardless of broader underlying rate environments. As Odeta pointed out, industrial, particularly driven by online retail, and multifamily, young millennial demand, are both benefiting from strong demand relative to supply. Offices and hotels, on the other hand, are requiring higher returns because of all of that future uncertainty.

Odeta Kushi - Well, I think that brings us to the end of the episode. I think this topic has a lot of 'potential.' Get it, get it? We can talk more about commercial in the future.

Mark Fleming - Yeah, 'potentially.'

Odeta Kushi - Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at We love to hear from our listeners. And, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.


This transcript has been edited for clarity.