Analysts and investors have been concerned about an apparent disconnect between the real estate capital market and space-market fundamentals for many months. Vacancy continues to increase nationwide, but cap rates have shown no sign of weakening — until now. A report by Boston-based Torto Wheaton Research says that cap rate spreads from the risk-free rate are indeed moving down together, proof that trends in the real estate capital markets are tied to market fundamentals.

Using appraisal-based cap rates from the National Council of Real Estate Investment Fiduciaries (NCREIF) and transaction-based cap rates from the National Real Estate Index (NREI), Torto Wheaton concludes that office cap rates have been waning since the second half of 2002. And a shorter transaction-based cap rate series from Real Capital Analytics (RCA) shows trends very similar to the NCREIF data for 2001 and 2002.

During 2001 and 2002, the national office market posted a 15-year record-low net absorption. This, in turn, drove the national vacancy rate up from 8.6% during the fourth quarter of 2000 to 16.5% during the fourth quarter of 2002. Nominal rents dropped about 16% in response to the rapid vacancy increase, according to Torto Wheaton.

To be sure, Torto Wheaton admits that simply juxtaposing cap rate levels with the market fundamentals gives the impression that a disconnect exists. But that would be true only if cap rates were solely driven by market fundamentals, which Torto Wheaton says isn’t the case. Market fundamentals may drive cap rates in part, but the real interest and inflation levels are also key components. Therefore, the likely explanation isn’t that market fundamentals no longer matter — rather, the downward pressure exerted on cap rate levels by the lowest interest rates in 40 years is stronger than the upward pressure exercised by weak market fundamentals.

By Torto Wheaton’s logic, the vital issue from a pricing perspective is simply when will the economy and, by extension, the real estate market recover, and when will interest rates climb back to their long-term average? That’s impossible to predict, although most economists maintain that rates will begin to climb once the economy starts gaining momentum.