If You Don't Understand Bonds, You Don't Understand Commercial Real Estate
There are two sides to the rising interest rates coin.
By Paul Rubillo ·
StripMallGuy posted something blunt this week: if you don't have a good understanding of the bond market and how it impacts commercial real estate, you shouldn't be investing in it, advising on it, or brokering it.
Here's exactly why bonds sit underneath nearly every number a commercial real estate investor cares about.
Cap rates are a bond market derivative, whether people admit it or not
We've already walked through this directly on this site: the 10-year Treasury yield recently climbed above the average rental cap rate. This is not something you typically see happen in a healthy market.
Cap rates are priced as a spread over the risk-free rate, compensating investors for illiquidity, vacancy risk, and active management. When the 10-year moves, that spread either holds, meaning property prices adjust, or it doesn't, meaning the asset is mispriced. Commercial real estate has spent the better part of two years with cap rates adjusting too slowly to catch up to where yields actually are.
The debt side is where this actually breaks people
Commercial real estate runs on leverage, and almost none of that leverage is a 30-year fixed rate the way residential mortgages work. CRE debt is typically 5, 7, or 10-year terms, often with floating rates or rate caps that expire. Every dollar of commercial debt originated during the near-zero rate years eventually has to refinance into whatever the bond market is offering when that term ends.
A building bought with a 3.5% loan in 2021 that comes due in 2026 isn't refinancing at 3.5% anymore. It's refinancing at whatever the current Treasury-plus-spread math says. The worry comes when the owner either has to inject fresh equity, sell at a loss, or hand the keys back.
Rate volatility is its own tax on these deals
We just talked about the worst quarterly move in the 10-year since 1994, an 87 basis point swing in three months. Lenders can't confidently underwrite a deal when they don't know what the 10-year will do between the term sheet and the closing table.
Buyers can't confidently bid when their financing cost could move meaningfully before they close. Volatility itself, independent of the direction yields eventually settle in, is enough to stall deal flow across the entire asset class.
Duration mismatch is the hidden killer
An owner holding a long-lived asset financed with short-duration debt is making the same bet a bond portfolio manager makes when they go short duration expecting rates to fall. When that bet is wrong, and rates instead do what they've done this year, the refinancing gods don’t care how good the tenant roster looks.
Why floating rate debt isn't automatically the safe choice either
Floating rate CRE debt protects against being stuck with a below-market fixed rate, but it offers zero protection against the kind of rate spike we've seen this year. An owner with floating rate debt during a quarter like this one just watched their debt service cost climb in real time with no floor.
The bottom line
Every input that makes a commercial real estate deal pencil, the cap rate, the loan rate, the refinance assumption, the exit multiple, traces back to the bond market in one way or another. Someone who doesn't track what the 10-year is doing is missing the key variable that determines whether their deal still works in three years!