Commercial Real Estate and the Cap Rate Conundrum!

August 23rd, 2014
in contributors

by Michael Haltman

Cap Rates: What they are and where they are heading!

For commercial real estate the term capitalization rate, better known as the cap rate, is one of the key measures that can define the attractiveness of an income producing property!

The cap rate is simply calculated by taking the net operating income of a building, or the cash flow after expenses (NOI), and dividing that number by the cost of the building.

Follow up:

If for example the NOI of a building is $100,000 and the price of the building $1,000,000 then the cap rate will be $100,000/$1,000,000 or 10%.

Typically the more attractive an area is considered the lower the cap rate will be. If for example that same property in the example above was in a 'better' neighborhood with a value of $2,000,000 with the same NOI of $100,000, the cap rate would drop to 5%.

A general rule of thumb when looking at a property is that you would like your borrowing costs to be below the cap rate of the building that you are buying. For example it would be desirable that if you were buying a 5% cap rate building that your borrowing costs be less than that number.

Today, however, particularly in 'hot' markets like New York City, the presence of a cap rate above the rate to borrow is not always the case.

This condition brings us to the conundrum of cap rates in certain cities around the country where they have dropped to historically low levels, evening reach 0% in some Manhattan transactions.

How does this happen? Several ways including the demand for yield, too much capital chasing too few deals and investors assuming that both property values and rents will continue going up.

Multifamily Executive recently published an article on this subject provided below titled 'Cap Rates Fall to Historic Lows as Investors Chase Yield Far Afield'!

It's been a common question as the apartment recovery matured: When will cap rates stop falling in the so-called "sexy six" markets of New York, Boston, Washington, Los Angeles, Northern California, and Seattle?

Well, if you guessed the first half of 2014, you were wrong.

In its "Apartment Mid-Year Review," New York-based firm Real Capital Analytics (RCA) reported that cap rates fell to 4.4 percent in the second quarter, equaling the historic low established in the second half of 2006. For mid- and high-rise properties, yields came in at 3.9 percent after they blew past previous lows in 2013.So much for fears cap rates were getting too low in the gateway markets.

"There is so much capital pouring into those big six markets that even if many investors are concerned about valuations, there are plenty of investors still competing fiercely for those properties that the investors with concerns have passed on," says Ben Thypin, director of market analysis at RCA.

While volume increased insecondary and tertiary markets, average and top quartile yields for garden properties in non-major metro areas have actually gone up in 2013. Overall, garden cap rates came in below 6.5 percent and mid- and high-rise cap rates were below 5 percent.

Soultana Reigle, managing director for Prudential Real Estate Investors says concerns about exit strategies are part of the caution institutional investors have in these markets. But she is still investigating secondary markets like Pittsburgh.

"If you reach out into the second tier, you can find better yields," Reigle says.

Prudential certainly isn't alone in its institutional interest in secondary markets.

"We made strategic decision to do a fund primarily doing multifamily and retail in secondary markets," says Ron Miller, director of acquisitions for Invesco Real Estate. "But we're still very active in core markets. We have core funds with a lot of core clients."

Overall, Philadelphia, Portland, and Baltimore climbed the highest in RCA's list of top apartment markets (by volume) in the first half of the year. Markets that were in major metros, but not downtown, like the New York boroughs (as opposed to Manhattan) and Orange County, Calif., (as opposed to Los Angeles) also jumped in the rankings.

Thypin said:

"There's definitely a shift to secondary markets, especially those within large metro areas"

But the biggest spikes in first-half volume were in places like Colorado Springs, Tallahassee, Pittsburgh, Tulsa and Birmingham. "Investors are now going out to compete in secondary markets," Thypin says.

While cap rates haven't reflected this increased competition yet, Thypin thinks as interest heats up, cap rates will eventually fall.

"I would be surprised in six months or a year if cap rates weren't going down in these markets," he says.

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