by Rachel L. Richardson
Definitions
An actual capitalization rate, otherwise known as a cap rate or overall rate, is calculated by taking a property’s net operating income (NOI) and dividing it by its total value (the sales/purchase price). The result is an indicator of the projected rate of return for a commercial real estate (CRE) investment.
For currently held or gifted properties, the property owner may instead calculate a cap rate by dividing the NOI by an estimate of the current market value rather than the sales price. CRE participants may also calculate the pro forma cap rate using the property’s projected NOI (adjusted to reflect elements like rent increases, potential vacancy, and so on).
As an investment indicator, a low cap rate is typical of stable, long-term leases to credit tenants—a comparatively low risk, low reward scenario. A high cap rate, though, is typically indicative of a riskier investment and a need to ensure the annual income is both realistic and sufficient enough to make the investment viable. Properties may have a higher cap rate if there is concern the tenant will terminate the lease prematurely, the income stream is hard to verify, or the property will soon require substantial repairs or maintenance to keep it operable.
Executive Summary
- Cap rates, like market trends, are cyclical.
- Periods of higher interest rates historically lead to higher cap rates, though this transition may occur somewhat slowly.
- Beyond investor expectation, a property’s characteristics and market also influence where its cap rate will fall in a sales transaction.
- With rising interest rates, cap rates may return to pre-pandemic levels.
- The market is in transition, and market participants will be watching marketing times, sales prices, and closing cap rates amid this period of price discovery.
Influences
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.”
Building and region
“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.
Investor perspective
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.
Expectations
With interest rates on the rise, Marcus & Millichap suggests hotels and some retail may gain investment appeal—the former due to rate flexibility and the latter to the stability of longer leases (particularly those with credit tenants and triple net structures). They also note office vacancies have continued to rise, particularly in older spaces, while decreased consumer spending may soon affect good imports and lower demand for industrial warehousing.
Commercial Property Executive finds that in recent months some opportunistic sellers have withdrawn their listings, while there has been both a mismatch between buyers’ and sellers’ pricing expectations and a widening spread in the difference between asking cap rates and confirmed sale cap rates for net-leased properties. They expect an ongoing “price discovery” through the end of the year and into 2023 as sale volume slows and investors raise their cap rate thresholds for future acquisitions.
Third quarter 2022 report by PricewaterhouseCoopers echoes this sentiment, noting how investors are taking a more reserved approach to acquisitions while keeping an eye on rising interest rates and how the markets react. The gap between asking prices and bids, they believe, will narrow as recently closed deals set new pricing expectations.
These new expectations may settle in slowly, though, according to a Berkadia report (focusing on multifamily) that describes a high level of autocorrelation among cap rates. “The statement ‘yesterday’s cap rate is the best predictor of today’s cap rate,’” they write, “is empirically true. …Cap rates tend to have a positive influence on themselves over time or carry with them a great deal of momentum.”
So what does this mean for market value? In this transitional period, Meek said she will be keeping a close eye on vacancies, marketed cap rates, and marketing times. Cap rates may eventually settle back into their pre-pandemic levels, she adds, with figures near what they were before the decrease in interest rates. Through it, as always, the key for appraisers (and investors) remains—read the market.