“While ratios (price to earnings, debt-to-equity) are commonplace in most value discussions, there is perhaps no other industry that relies on such a singular metric as real estate does on capitalization rates."
A surprisingly simple ratio - total mortgage debt outstanding divided by GDP - can predict commercial and residential real estate cap rates with startling precision. When mortgage debt grows faster than GDP, cap rates compress. If the inverse happens, they expand. The study that uncovered the relationship between mortgage debt fund flows and cap rates illustrates how demand for mortgage debt is a proxy for “the amount of capital seeking real estate,” and below we will look at why this ratio works, how well it predicts cap rates, and a novel idea about what America could do with it.
The study's model - which uses fund flows into/out of mortgage debt plus historical cap rates (for the asset class in question) and U.S. unemployment - found that when mortgage debt grows 100 bps faster (slower) than GDP, cap rates fall (rise) by 22 and 65 basis points for multifamily and office properties respectively. In other words if debt grows by 10% relative to GDP, cap rates stand to compress by 220 to 650 basis points.
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