By: John Flint, Executive Vice President, Asset Management and Strategic Initiatives
Capitalization rates, cap rates for short, are one of the most critical factors when assessing commercial real estate.
The cap rate is the ratio of Net Operating Income (NOI) to asset value. For example a property valued at $1 million that generates an NOI of $100,000 has a 10 percent cap rate.
The ratio is used to measure the expected yields on investment property.
Real estate is no different than other types of investments in that the higher the risk, the higher the return an investor expects to earn. Risk factors include creditworthiness of the tenants, location, and the dynamics of the local real estate market.
In general, lower cap rates indicate less risk on an investment (evidenced by increased demand for that investment) while higher cap rates typically signify a property carries higher risk.
Cap rates can also be influenced by demand. The lack of risk-adjusted return availability causes investors to bid up prices for assets. In other words, last year an investor may have only paid $1 million for an asset, but today will pay $1.1 million. Nothing fundamentally has changed with the asset, but investors are willing to accept a lower rate of return because they don’t have any good options.
So what are the current cap rate trends?
The National Association of REALTORS Commercial Real Estate Market Trends Report for the third quarter of 2015 showed average cap rates of 7.9 percent across all sectors, 26 basis points lower than the third quarter of 2014.
Apartments posted the lowest cap rate, at 7.6 percent, followed by retail properties with average cap rates at 7.7 percent. Office and industrial spaces posted cap rates of 7.8 percent. Hotel transactions reported an 8.8 percent average cap rate.
Cap rates for all five categories are down from their 2010 levels when each sector had a cap of around 9 percent — hotel properties averaged 10 percent cap rates that year.
Retail, office and multifamily have experienced the most volatility during that period. Office caps peaked at nearly 11 percent during the third quarter of 2014, while retail caps plummeted to nearly 5 percent during 2011.
These figures may mean that real estate investing is offering less risk than it did in the years just after the financial crisis, but are also offering lower potential yields. Alternatively, it could mean that the risk profile hasn’t actually changed, there is just so much demand for quality assets that prices are climbing, and cap rates are dropping.
The current market reveals that there are a lot of buyers that are anxious to put capital to work, and are being very aggressive on pricing to accomplish this goal. Will it last? Will it get better for sellers? Is there a bubble forming, and buyers should sit tight and wait for an adjustment?
If you think I have the answers, e-mail me and I’ll give you next week’s Powerball numbers.