Karen Meek, MAI and a Senior Managing Director of Valbridge Property Advisors | Inland Pacific Northwest, noted that cap rates are influenced by property type, tenant, and lease structure. Other factors include investors perspectives and the cyclical nature of commercial real estate. “Real estate has always been cycles—ebb and flow,” says Meek. “When I started appraising, cap rates were nine and ten percent. So, to me, six percent is still pretty low. It’s all kind of relative to market conditions and demand.”
“The older the project,” Meek shares, “the greater the risk of expenses going up” which translates to a higher cap rate. When a building is nearly due for major repairs, such as new roofing or HVAC, an investor will need to allocate more of the gross income toward replacement reserves and maintenance expenses, decreasing both the total NOI and the amount an investor would be willing to pay for the property. Similarly, outdated interior finishes can lead to vacancies or lower rents and these finishes will eventually need to be replaced to keep the property marketable.
Location, of course, also plays a role. Properties in areas with high traffic volumes or thriving market dynamics are typically less risky than rural areas with less traffic or lower likelihood of development and growth. These areas in greater demand promise higher occupancy rates and, if there is little threat to over-development, continued rental rate appreciation.
Property and lease type
In general terms, multifamily cap rates are often low, Meek explains, since the comparatively short lease terms allow for frequent rental rate increases and the stable demand presents relatively low risk. Despite the rising interest rate environment, Berkadia reports the national multifamily cap rates for Q3 2022 are down 10 basis points YTD. Likely, this is an indication of continued interest in this property type as a comparatively low-risk investment in the current macroeconomic environment, as buyers are willing to have less leverage in exchange for the anticipation of greater stability and appreciation over the long term.
Industrial properties have a high owner-occupancy rate, so there are fewer sales with cap rates. As a subcategory of industrial, self-storage (which does not require much in the way of interior finishes) imitates the same trends as multifamily properties with higher turnovers, frequent rent increases and generally low operating costs leading to lower cap rates.
Retail cap rates will fluctuate greatly depending on tenant type (the relative security of larger, credit tenants, versus the risk associated with a smaller, independent retailer or restauranteur), remaining length of lease term, renewal options, and location.
Office, Meek adds, typically involves longer lease terms than multifamily and self-storage (at three to five years) and often there is some built-in increase—either a specified yearly rate or an adjustment by the increase to the Consumer Price Index (CPI). Of the main four property types, she adds, “office is probably the highest risk if they are not triple net leased and remote working situations are causing many companies to reexamine physical office space needs.”
“A triple net lease lowers the owner’s risk,” Meek notes. “Insurance isn’t going up a whole lot, but if we have a utility surge or something come up, (for) all those on a triple net lease, that’s the tenant that takes the hit, not the owner.” Investment-grade properties with credit tenants (and lower cap rates) are most often structured in NNN leases.
Given the current inflationary environment and the interest rate hikes enacted by the Federal Reserve to curb it, investors are anticipating that cap rates will rise over the coming months, which the third quarter PricewaterhouseCoopers (PwC) Investor Survey says, “can negatively impact property values and pricing.” The driving force behind the escalation in cap rates would be that of decreasing sales prices (rather than increasing NOIs) as the greater cost of borrowing slows deal activity and decreases leverage. Meek notes, however, that “a seller can stick to their price and an ‘all-cash’ buyer could still be willing to pay for it, so higher interest rates don’t exactly equate to lower prices/values.” In keeping with supply and demand trends, attractive investment opportunities considered to be more stable have retained lower cap rates despite the increase in interest rates.
Still, with more costly financing and inflationary pressures adding to operating expenses, investors will typically require a greater return-per-dollar at the outset for the investment to remain attractive. In this environment, some owners will hold off on listing their properties for sale, while those offering lower cap rates may find their properties languish on the market as investors seek greater returns elsewhere.
Of course, the cost of borrowing doesn’t play a role in all-cash acquisitions, nor will it bear as much weight in investments with a lower loan-to-value ratio. Further, cap rates may play a more marginal role in 1031 Exchange transactions as participants experience the pressure to close on their upleg/replacement properties in a timely fashion, to reap the tax deferment benefits. Still, liquidity has been declining and 1031 Exchanges, at an estimated 12-20% of all transactions nationwide, remain a minority share of the total market activity.