Declining Treasury Yields Driving Cap Rates to Record Lows

(Re-printed with permission from Rick Hayward of Johnson Capital)

The Federal Reserve’s recent announcement of a new, open-ended program of asset purchases, starting with $US40 billion per month in mortgage-backed securities (MBS), is the third in a series of quantitative easing (QE) initiatives undertaken by the central bank.

The cornerstone of these initiatives is the Fed’s ongoing purchase of MBS issued primarily by Fannie Mae, Freddie Mac and FHA. The Fed’s purchases reduce the supply of these securities in the marketplace, reduce interest rates in the Treasury market and allow the agencies to make new loans at lower interest rates (to be funded by the sale of newly issued MBS).

When the Fed started purchasing MBS in late November 2008, the yield on the 10-year Treasury note was approximately 3.9%. As we approach the 4th anniversary of the QE1 announcement, the yield on those same notes has been bid down 225 basis points, to approximately 1.65%. Yields are poised to remain at these levels, or lower, as the Fed has indicated that it will continue the QE3 actions until at least mid-2015.

Interest rates have historically fluctuated a great deal - they were 4% in the early 60s and rose to 14% in the early 80’s. However, prior to the QE initiatives, long-term interest rates have not fallen below 4%, and they have never fallen as dramatically in such a short amount of time. Although multifamily spreads have widened 100+ basis points from the historic lows seen in 2006-07, the interest rates on the mortgages that comprise these securities for both single and multifamily properties are at record lows.

There has never been a better time to be a real estate borrower, when interest expense on mortgage debt is factored into the investment decision. Needless to say, the caveat is that property values have to be at levels that support the required or desired level of debt. But the Federal Reserve’s recent actions are indirectly lowering cap rates and increasing property values, especially for multifamily properties.

Key to the investment decision-making process is the rate of return on equity (ROE) invested in a property. For purposes of the following example, the desired ROE is 6% over 10-year Treasury yields, where 6% is deemed to be a reasonable “risk premium”.

In 2005-2007, an investor could obtain a 75% loan to value, 5.5% interest rate 10-year fixed rate mortgage, acquire a property with a 6.60% cap rate and achieve a return on equity equal to 6% over 10-year Treasury yields.

Today, as 10-year Treasury yields dip below 2%, an investor can acquire the same property at a price that implies a 5.20% cap rate and achieve the same return relative to Treasuries on equity utilizing a 70% of value, 4.0% interest rate, 10-year fixed-rate loan.

Careful readers will notice that the equity requirement increases to 30% in this scenario, as the debt coverage for a 75% loan at a 5.0% indicated cap rate is below the current minimum threshold of lenders offering loans on the indicated terms. In effect, the lending community has been throttling the Treasury yield-driven decline in cap rates by tightening their underwriting guidelines.

The American Council of Life Insurers (ACLI) reports that the average cap rates for a high quality, life company-owned multifamily property is currently at 5.5%, a rate similar to the historical lows achieved in 2009 Q4, and continuing to trend downward. Over the past 45 years, the spread between 10-year Treasury yields and cap rates, as reported by ACLI, has been approximately 200 basis points, which implies a sub-4% cap rate in the current treasury yield environment.

Clearly, investors are driving cap rates lower in response to the actions of the Federal Reserve. How low they may go depends on a range of factors, including possible changes in investor yield requirements, further tightening of lenders underwriting guidelines or a change in the level of market acceptance of the Fed’s actions.

Stay tuned.

Rick Hayward is the Senior Director in Johnson Capital's San Francisco office. He can be reached at (415) 728-6600 or

Founded in 1987, Johnson Capital is one of the country’s top real estate capital advisory firms with eighteen locations nationwide. Their services include debt placement and acquisition financing for permanent, construction and repositioning in addition to joint venture equity placement for individual assets, portfolios, entities and discretionary funds. Johnson Capital transactions have ranged in total funding from $1 million to over $300 million and have financed all property types, including: multifamily, office, retail, industrial, hotels, mixed use, manufactured housing, credit-tenant leases, single-family housing and land developments. For more information about Johnson Capital, log on to their website at:

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