Grading Multifamily and Cap Rates On the (Treasury Yield) Curve

There is no doubt the current economic landscape has become increasingly difficult to ascertain. From still rebounding from the effects of a worldwide pandemic, to flushing out historic levels of stimulus, to now seeing an attempt at “rightsizing” with unprecedented interest rate hikes, volatility has become the name of the game with investing in all aspects of the economy. However, few elements get tossed about as does the 10-year Treasury value, though many of us have little idea of the role it plays in the economy and, evenmoreso, of its particular connection with multifamily real estate.

THE 10YR TREASURY

In its simplest form, the 10yr Treasury is a fundamental indicator used across numerous industries as a harbinger of where the economy is headed. Its also commonly associated with predicting the direction investor’s inflation expectations and even mortgage rates.

Basically, the 10yr Treasury (or T-Note, T-Bill, or T-Bond in its various forms) is an obligation of a 10-year debt issued by the federal government. The interest rate is fixed, making it – in essence – a loan you are extending to the government, with ten years the longest term they utilize. These notes also come shorter terms, including 2,3,5, and 7-year terms – but even as low as 3-months.

Rather than focusing on the exact value of the 10yr, the direction and momentum are the key indicators here, as an increasing yield from the 10yr Treasury suggests a decreasing demand from investors – indicating an increasing preference for higher-risk, higher-reward options. Such a preference would point towards greater confidence in the state of the economy and a predicter of future economic behavior. Conversely, a loss in confidence typically results in a move by investors towards safer alternatives, such as Treasury notes and bonds. This move sparks a drop in Treasury yields due to the demand shift. Still, when the 10yr yield falls (and mortgage rates subsequently decline), the housing market strengthens as a result – and leads to further positive impact on economic growth and the economy overall.

De-Constructing Treasury Yields

The Treasury Yields that are being scrutinized are the result of secondary market activity. An investor originally purchases a 10yr T-note, for example, which is sold to institutional investors – who then sell these notes to investors in the secondary market. It’s the activity here that largely sets the “yield,” or what is largely acknowledged to be the Treasury rate. What is notable here, is that the actual prices of these instruments are constantly in fluctuation; and that fluctuation is a result of the rising or falling investor demand. It’s the reason why these rates carry the weight and attention they do in assessing the current and future state of the economy.

And its not just an impact upon individual consumers and mortgage rates. The 10-yr Treasury Yield influences myriad other interest rates and even impacts the rate at which companies can borrow money. For example, a high 10yr yield leads to more expensive borrowing costs and could hamper a company’s ability to undertake projects needed to grow, expand, innovate.

The 10yr yield also impacts the stock market. Dramatic shifts in yield trigger volatility in the market that may cause some investors to shift cash away from stock investments. Such movement ultimately lessens the movement of cash into organizations, further impacting their ability to undertake growth activities.

Cap Rates & 10yr Yields

Capitalization Rates and 10yr rates have historically maintained a relationship between that has resulted in a spread of 2%-4%. This becomes another reason for the 10yr Treasury to serve as an indicator of investor sentiment, as the yield spread is an illustration of the additional risk that accompanies real estate investment (versus the low-risk investment of anything backed by the federal government). In real estate, lower Cap Rates accompany lower risk and often have minimal spreads between them and the 10yr Treasury – as opposed to higher Cap Rate investments with higher growth and higher risk. When investors feel increasingly – and consistently – confident to continue paying more for lower Cap Rate properties, the 10yr Treasury is reflected throughout a more vibrant economy. The spread between Cap Rate and 10yr Treasury Bills is illustrated below.

As you can see from above, following the Tax Cut Act of 1986 and the ensuring few years, cap rates were lower than the 10-year Treasury yield. In the face of high inflation, the 10-year Treasury yield skyrocketed, while real estate cap rates remained relatively flat.

In fact, earlier data even show the period from 1980 to 1985 had significantly higher 10-year Treasury yields than the implied cap rate. Notably, incorporating 10yr Treasury yields into the fight against inflation has proven complicated. Because of this, the 10-year Treasury rate and inflation (since 1978) maintain a correlation of about .65, indicating a relatively strong relationship. This is actually far higher than the correlation between any of the property type cap rate series and inflation. For comparison, real estate fundamentals have a correlation of about .85 with job growth. Thus, confidence tied in with job growth propels real estate fundamentals to healthy levels, subsequently keeping Cap Rates low. More directly, however (and notable for our edification) recent data depict a 1% increase in 10yr T-Bills will increase Cap Rates by around .30%.

And the following chart graphs the relationship specifically with U.S. Multifamily Cap Rates and the 10-yr Treasury Rate over the last two decades.

“Because I was Inverted . . .”

We are constantly hearing about the inverted yield curve of the 2yr and 10yr Treasuries. Which is, to say, that intuitive thinking that one would receive less of a return on shorter-term investments (i.e. 2yr, as opposed to 10yr). When those values invert (the 2yr Treasury yield spikes higher than the 10yr), history has suggested a recession is around the corner – from a few months to 18 months away.

The U.S. Treasury yield curve has now been inverted since July 6, 2022 – and each of the last three recessions all were preceded by yield curve inversion.

Should yield inversion remain and – even worse – and recessionary economy worsen and last for an extended amount of time, the importance of real estate as an investment vehicle will only heighten. The inflation rate will also be a significant variable in this picture, and we know that the 10yr Treasury maintains a strong relationship with the inflation measure. More importantly, the overall value of real estate is one that responds favorably to the inflationary fight and will still be able to deliver some returns upon one’s investment.

But most importantly, you will now know why we will be keeping our eye on the 10yr Yield, the Treasury Yield Curve, and the lagging Cap Rates.