Cap Rate Validation

4th Quarter 2019

Market Watch
by Joe A. Hollingsworth, Jr.

As industrial developers, we live and die by interest rates.   While supply and demand affect the market tremendously, the interest rate on medium to long-term borrowings dramatically affect the outcome in rents.  Many of us have stood on the sideline and watched cap rates drop from 10% and 11% down to 5.5% to 6.5%.  Although we have been shocked (and in some cases utterly astounded) on how far they have dropped, the market has clearly been giving us signals that we all will sooner or later adopt.

The global financial challenge is evident where $13 trillion out of $33 trillion worth of bonds have negative yields which forces you to pay a fee to allow financial institutions or sovereign bonds to hold your money; it’s a paradigm quake.    I don’t think the market could send us a louder signal.  For the first time in hundreds of years, half of the world may soon be in negative yields.  Hypothetically, if there is a negative 1.5% financial yield, and you have a 5% cap rate on a real estate investment, the spread is still 6.5%.  Many of us are willing to invest in that long-term scenario.  The trick will always be matching your long-term rental structure with long-term maturities.

The naysayers of the world are always worrying about “the sky is failing” and will say negative interest rates in America would devastate the financial system, even though this has proven to be false elsewhere in the world.  Japan has experienced a deflationary period for the last two decades. Admittedly, it is unusual; and, it requires a paradigm shift in investment strategy.  However, it is workable.  I think the United States Federal Reserve is faced with the stark reality that if they don’t lower interest rates that America (with the world’s largest economy) won’t be able to continue to pull the world’s GDP along with it.  Clearly, China is a “debt bubble” waiting to pop, which we consider the greatest threat; and, behind that, the next largest threat to the world is the United States Federal Reserve not realizing they need to adjust rates rapidly.  A 0.5% adjustment in the interest rate could grow our exports by 4.5% (due to a lower exchange rate on the US dollar) making a huge difference in the manufacturing sector and our economy.  With manufacturing currently onshoring to America at a rapid rate, I would predict that with the interest rate move that manufacturing could be growing at double the rate that it has over the last couple of years.  Together, this will keep us from following into Japan’s deflationary cycle.

All that being said, maybe the 5.5% to 6.5% cap rates are defining our future for us; and, those that are locking in returns at that level could have captured “the goose that lays the golden eggs”.

“Joe Hollingsworth participated as one of our first equity investors. In addition, Joe Hollingsworth has served as a board member and leading advisor for strategic planning and direction.” — Scott Kelley, President and CEO, Service Center Metals