A capitalization rate, or cap rate, is a commonly cited metric which indicates the potential return that can be earned from a commercial property. Not as common, a cap rate spread represents the difference between the cap rate of a commercial property and the current interest rate of the 10-year Treasury note.

The cap rate spread is often utilized as an indicator of risk. Since U.S. Treasury bonds are often considered to be free of risk — while commercial real estate investment has a much larger degree of perceived risk — the difference between a commercial property’s estimated return and the accompanying U.S. Treasury rate is referred to as the risk premium.

Risk premiums account for any yield in excess of the risk-free return an investor may have earned through a 10-year Treasury bond. Risk premiums are typically thought of as compensation for investors for tolerating extra risk involved in holding commercial real estate assets.

The cap rate spread is often utilized as an indicator of risk. Since U.S. Treasury bonds are often considered to be free of risk — while commercial real estate investment has a much larger degree of perceived risk — the difference between a commercial property’s estimated return and the accompanying U.S. Treasury rate is referred to as the risk premium. Risk premiums account for any yield in excess of the risk-free return an investor may have earned through a 10-year Treasury bond. Risk premiums are typically thought of as compensation for investors for tolerating extra risk involved in holding commercial real estate assets.

The higher the cap rate spread, the more likely the economy is underperforming. This can lead to higher loan rates for apartment loans, as lenders may be more likely to charge higher rates to account for the increased risk. Conversely, periods of economic stability and growth typically coincide with a lower cap rate spread, which can lead to lower loan rates for apartment loans.

Understanding the capitalization rate of an asset and of comparable assets in the same market is invaluable in commercial real estate investing. In a similar vein, having a firm grasp on how to properly utilize cap rates and cap rate spreads can mean the difference between a successful investment and a grand flop.

Falling rents or rising vacancies can often be enough to churn up panic over perceived risk in a market, causing cap rates to rise, and thus increasing the cap rate spread. As stabilization occurs, cap rates fall, and the spread usually decreases. Timing this cycle correctly can lead to substantially better investment decisions.

If an investor can source historical cap rate data for a relevant market, they may be able to estimate the stage of this cycle the asset is currently in. In many cases, it proves to be a highly beneficial move for investors to acquire a property when cap rates are high, effectively discounting the price of the source of income in relation to the same acquisition in a low cap rate environment. And while this may outwardly seem like taking on unnecessary risk, it goes right back to analyzing the historical cap rate cycle and investing at the right time. Getting in when cap rates are at their peak is the ideal scenario — a correction may take months, but as the spread begins to decrease, rents typically begin to rise, providing for a much better return on an investment.

The factors that influence cap rate spreads include:

• Property Type/Condition: Hospitality properties are generally some of the riskiest property types eligible for multifamily loans, while the safest property types include traditional multifamily and commercial properties. In addition, higher quality properties (think Class A) are less risky, while poorer quality properties (think Class C) are riskier and command higher spreads.
• Cash Flow/DSCR: The greater a property’s cash flow relative to its debt obligations, the safer a loan will be, and the lower its spread (and vice versa). The minimum DSCR for most CMBS-eligible property types is 1.20-1.25x DSCR, but riskier property types may need 1.40-1.50x DSCR to qualify.
• Loan Term/Size: Larger loans typically have lower credit spreads, while longer-term loans have higher spreads. For instance, a large, short-term loan would have the smallest spread, while a smaller, long-term loan would have the highest spread.
• Leverage/LTV: The average maximum LTV for a CMBS loan is 75%, but this can vary based on other risk factors. Highly desirable properties may be permitted LTVs up to 80%, while riskier properties may only be allowed 70%. Higher LTVs typically lead to higher spreads, as they increase the risk for lenders.
• Lease/Tenant Strength: If the tenant in a commercial property is a large corporation with a long-term lease (for instance, if a credit tenant lease is involved), CMBS spreads are usually lower, while smaller or lesser known tenants may face higher spreads.

The difference between a cap rate spread and a cap rate is that a cap rate spread represents the difference between the cap rate of a commercial property and the current interest rate of the 10-year Treasury note. The cap rate is a metric which indicates the potential return that can be earned from a commercial property. To calculate the cap rate spread, an investor must first determine the cap rate of the target property, which entails dividing the asset’s net operating income by its current market value. Next to the cap rate, the next metric of importance is the current interest rate of the 10-year treasury note. In order to determine the cap rate spread, an investor must calculate the difference between the two.

Source: Apartment.loans

The cap rate spread is a useful tool for investors to gauge the risk associated with a commercial real estate investment. By calculating the difference between the cap rate of a property and the current interest rate of the 10-year Treasury note, investors can gain an understanding of the overall state of the market, as well as make more informed decisions. By analyzing the current trend of the cap rate spread, investors can increase their chances of success in the commercial real estate market.

For example, if the cap rate spread is high, it may indicate that the economy is underperforming. In this case, investors may want to consider loan products with lower interest rates, such as a fixed-rate loan, to minimize their risk. On the other hand, if the cap rate spread is low, it may indicate that the economy is stable and growing. In this case, investors may want to consider loan products with higher interest rates, such as an adjustable-rate loan, to maximize their return on investment.