Inflation Will Likely Rise This Year But Cap Rates Should Trend Down

Article originally posted on Globe St. on April 29, 2021

Cap rates may compress during the latter half of this year, despite rising Treasury yields, as the economic recovery continues to follow a K-shaped trajectory.

A recent analysis from MetLife Investment Management notes that the US five-year inflation breakeven rate – which forecasts where the market believes inflation will be in five years – has reached its highest point (2.45%) since the aftermath of the Great Recession. This has been primarily stoked by an influx of financial stimulus as the broader economy recovers post-COVID.

Inflation will likely increase this year, according to MetLife analysts, though it will likely be more “transitory” and reflective of price volatility last year.

“We do not believe inflation is likely to remain high until slack from the labor market is removed, however,” the report notes. “Although this may occur in 2022 or beyond, for now we do not believe sustained inflation is likely to occur while the unemployment rate remains above 4%.”

Fears over rising inflation have already begun playing out with interest rates, with experts predicting the bellwether 10-year Treasury rate could end the year at 1.75% and the CPI-U could hit 2%. And while rising interest rates often lead to fears of rising cap rates, MetLife says the two are typically not correlated: “Because real estate is pro-cyclical,” the report notes, “the trend between interest rates and cap rates can be negatively correlated during times when the economy is expanding or contracting.”

It’s an opinion widely shared by other recent analyses among CRE insiders: as of now, “unanchored inflation” is unlikely, according to Cushman & Wakefield experts who say low interest combined with transparency from The Federal Open Market Committee justifies the valuation of interest-rate sensitive assets. And despite COVID-19, headline cap rates have actually moved very little since December 2019. Across product types, cap rate spreads are above the long-term average by about 100 basis points, indicating “an ability to absorb upward movement in the cost of capital without imminent pricing downsides,” according to C&W.

As we look toward the latter half of this year, MetLife experts predict the recovering economy will lead to a compressing cap rate spread to 10-year Treasuries and to declining cap rates generally.

“If treasuries rise to the mid-2% range, and U.S. GDP growth remains in the 5% to 7% range, then we would begin to be concerned about potential cap rate expansion,” the report states.”