What is Cap Rate Spread?
The Cap Rate Spread is the delta between the 10-year Treasury note yield and cap rates in the broader real estate market.
Table of Contents
- How to Calculate the Cap Rate Spread
- Cap Rate Spread Formula
- How to Analyze the Cap Rate Spread?
- What is the Risk Premium in the Cap Rate Spread?
- Cap Rate Expansion vs. Cap Rate Compression: What is the Difference?
- Why Does the Cap Rate Spread Matter?
- Cap Rate Spread Example: U.S. Fed Monetary Policy (2023)
How to Calculate the Cap Rate Spread
The cap rate spread is the percentage difference between the interest rate on the 10-year Treasury note and the cap rates of properties.
The spread reflects the incremental risk/return trade-off in purchasing a real estate property in lieu of a government bond.
A higher cap rate spread implies greater risk, while a lower cap rate spread indicates less risk.
The 10-year Treasury yield is therefore a proxy for risk in many industries, including real estate, to understand the current state of the economy and serve as a minimum rate of return hurdle for risky assets.
- Increase in Demand for the 10-Year Treasury → Higher Bond Prices + Lower Yield
- Decrease in Demand for the 10-Year Treasury → Lower Bond Prices + Higher Yield
In the real estate market, the cap rate is a financial metric that represents the potential rate of return expected to be earned on a property investment.
The step-by-step process to calculate the cap rate spread is a straightforward process:
- Calculate the Market Cap Rate (or Reference the Compiled Cap Rate Data from a 3rd Party Research Platform)
- Determine the 10-Year Treasury Yield Rate at Present
- Subtract the Market Cap Rate by the Yield on the 10-Year Note
Technically, the cap rate of an individual property could be used, rather than the consolidated average cap rate. However, a broader analysis could be more practical for understanding the current state of external risks.
But since the cap rate spread is a comparison performed to grasp the market dynamics from a macro perspective, the cap rates should typically be analyzed in aggregate.
Cap Rate Spread Formula
The formula to calculate the cap rate spread is as follows.
The formula to calculate the cap rate of a rental property, on an individual basis, divides the property’s net operating income (NOI) by its market value as of the present date.
- Cap Rate (%) = Net Operating Income (NOI) ÷ Property Market Value
- Net Operating Income = (Rental Income + Ancillary Income) – Direct Operating Expenses
On the other hand, the 10-year Treasury yield is readily available in all financial data platforms such as Bloomberg, as well as financial news sites like the Wall Street Journal (WSJ) and CNBC.
U.S. 10-Year Treasury Note (Source: Wall Street Journal)
How to Analyze the Cap Rate Spread?
Conceptually, the cap rate spread is comparable to measuring the default spread in the context of corporate finance.
For example, the equity risk premium (ERP) is the price of the risk associated with investing in the public equities market.
Therefore, the “premium” reflects the higher required rate of return demanded by investors to allocate capital towards stocks, instead of a theoretically risk-free investment.
The premium for investing in equities and bonds is termed the “equity risk premium” and “default spread”, respectively.
But rather than comparing the expected return on an equity security, or the yield on a corporate bond (or other financial security), to the risk-free rate, the cap rate is analyzed, as illustrated by the following formula.
The “Risk Premium” is the additional return that the property investor receives as compensation for undertaking the incremental risk in the real estate market.
Why? Investors expect to receive a reward for undertaking more risk. Otherwise, the decision to invest in risky securities with limited upside is not worth the trade-off, and it would be more reasonable to invest in government bonds instead.
- High Cap Rate Spread → Higher Degree of Perceived Risk
- Low Cap Rate Spread → Lower Degree of Perceived Risk