Capitalization Rates At Record Lows – Speculation or Prudent Investing?

by Michael Haltman

Interesting question but for many of those reading this article their first thought may actually be: What is a capitalization rate?

In the world of commercial real estate the way that an investor, or buyer of property, will evaluate that investment is through the simple equation known as the capitalization rate.

Simply the capitalization rate, or cap rate as it is commonly known, is calculated by taking the Net Operating Income of a property (NOI) and dividing it by the price of the property.

Cap Rate = Net Operating Income/Price of the Property

As an example if the NOI is $24,000 and the asking price or recent sales price is $300,000, then the Cap Rate is 24,000/300,000 which equals .08 or 8%.

If an investor were to buy this building given the criteria above his return would be 8% and, if financing were to be used, the rule of thumb would be that the cost of funds or mortgage rate would be below 8%.

In some areas of the country today, however, this has not necessarily been the case.

Some investors, spurred on by the availability of easy money worldwide, have been willing to buy property with a cap rate as low as 0% under the investment thesis that the capital appreciation of the building would be significant.

Put another way they are willing to buy at no immediate return, potentially incur the cost of financing unless they were paying cash, in order to enjoy the potential price gains that have been occurring over the past few years.

Sound familiar? If it does then you will recall the type of real estate buying (or speculating), particularly in the residential market, that went on before the financial crisis hit.

And now, according to a special report at MHNOnline, cap rates are at record lows.

Is it a problem? Some think it may be while others are not so worried

‘Lowest Cap Rates in History, Global Liquidity, Raise Fears of U.S. Commercial Property Inflation’

Miami-The flood of liquidity worldwide is leading to an increase in commercial real estate values, noted Ken Rosen, chairman of the Rosen Consulting Group. Rosen spoke at a luncheon presentation during the 2014 CREW Network Convention & Marketplace this week in Miami.

Rosen said that capitalization rates in the commercial real estate industry are now at their lowest levels in history. They are about 50 basis points below levels in 2007 prior to the financial crash. He said he “gets very worried” when cap rates register at these numbers.

Countries are trying to stimulate economies by putting in place extremely low interest rates, which are in turn driving the low cap rates for commercial property. The 10-year U.S. Treasury yield is now about 2.5 percent, while the equivalent rate in Germany is even lower, at 0.9 percent. Short-term rates in the United States are near zero.

Rosen said governments do not need to push interest rates to zero in order to stimulate the economy. Near-zero interest rates last occurred in the 1990s, and 2003 and 2004. Interest rates that stayed “too low for too long” are what in part at least caused the last recession, when asset prices had to undergo a process of being revalued down, he said.

The Federal Reserve may be concerned about deflation when it should be worried about asset inflation, and Rosen suggested that the Fed may have to correct an asset bubble in three to four years’ time. There is also no question that credit standards are eroding, but he said the question is by how much.

Despite his concerns about a possible asset bubble, Rosen said the U.S. economy is strong and on balance does not face “many headwinds” in the near future. He said while the economy lost 8 million jobs during the recession, 10 million jobs have now been created. He said job creation is leading to commercial property space rentals and young people moving out of homes to live in apartments.

There is no overbuilding in the commercial real estate sector on a national level, said Rosen, although Washington, D.C., may need to be watched closely. He said new production in multifamily, which reached the highest levels in 25 years, slowed down this year because of construction and land cost increases. Still, demand for apartments is strong; new deliveries are being absorbed so far; and in general there are no signs of slowdown in apartment rent increases.

‪The office sector is seeing a close-to 50-year low in new construction, but occupancy rates are not rising because companies are reducing their use of office space. Construction of retail real estate is also at historically low levels, but there is not a huge need for additional retail space in the country. Retail sales are acceptable-there is a “boom” in luxury retail, but performance in discount retail is not strong.

‪Construction is starting up again in the hotel sector, and rent growth can be very strong in certain segments. However, Rosen noted, there are also fears that there is too much money entering the sector, especially at the lower end. (Source)