Understanding the Current Real Estate Cap Rates










“We can easily forgive a child who is afraid of the dark;

the real tragedy of life is when men are afraid of the light”



REIS REPOrTS      by Ryan Severino on October 10, 2014 

Understanding the Current Real Estate Cap Rates

Any seasoned real estate professional should be familiar with the term Capitalization Rate or Cap Rate for short. The cap rate is a measure of a property’s investment potential, independent of the specific buyer. Regardless of who is evaluating the property, the cap rate will remain the same, and therefore two investors can do an apples-to-apples comparison of the same property using this measure. Investors, lenders, and appraisers use current ReisReports cap rates to estimate the appropriate purchase price for different types of income producing properties.

What is a market Capitalization Rate?

ReisReports determines the market cap rate by evaluating the financial data of similar properties which have recently sold in a specific market. In short, the cap rate is equivalent to the return on investment you would receive if you were to pay all cash for a property, and therefore, it is our way of making the complexities of property investment more transparent. By definition, the capitalization rate is a ratio used to estimate the value of income producing properties.

Cap Rate = Net Operating Income / Property Price

For example:
Purchase Price: $500,000
Income Per Month: $15,000
Expenses Per Year: $100,000
NOI = Annual Income – Annual Expenses or (12 x $15,000) – ($100,000) or $80,000
Cap Rate = NOI / Property Price or $80,000 / $500,000



Apartment Cap Rate Trends

The mean cap rate increased by 20 basis points during the second quarter to 6.6%. The mean cap rate is now on a bit of an upswing after bottoming out at 6.2% during the first quarter of 2013. Although the mean cap rate has fluctuated slightly since that time, an increase of 40 basis points is not insignificant. Moreover, if we look at the 12-month rolling cap rate, this also indicates that cap rates in the market have bottomed out and are trending upward. The 12-month rolling cap rate was virtually unchanged at 6.5%. Does this mean that pricing in the apartment sector is reversing course? Not really. What has occurred over the last year and a half is that the composition of properties that are changing hands has shifted slightly. Over time, a wider swath of the market has been trading hands – more deals of lower quality and more deals in secondary markets are occurring. Because these deals trade at somewhat higher cap rates the affect is to pull up overall market cap rates. However, cap rates on the highest-quality deals are still changing hands at incredibly low cap rates so there is no respite there. So in a counterintuitive way, market cap rates are actually rising because good deals are so heady, forcing investors chasing yield into further reaches of the market. Once this expansion is complete, expect overall market cap rates to drift lower again as pricing for those other deals heats up too.



Office Cap Rate Trends

During the second quarter, the mean office cap rate decreased by roughly 20 basis points to 6.7%. Once again, the office market reached a new post-recession low for cap rates. The mean office cap rate is now roughly 160 basis points below its cyclical high of 8.3% which was attained during the first quarter of 2010 just after the economy began to recover. Unlike the apartment market, transactions in the office market remain rather concentrated in a small number of key markets. As demand for assets in these markets remains robust, pricing continues to increase putting downward pressure on cap rates. There remains relatively little interest in lower-quality deals and secondary markets these days, although some rumblings about those properties occurs from time to time. But it is mostly just chatter and not any meaningful change. Although we ultimately expect transaction activity to spread to a greater number of markets that is going to take some time to occur. For now, with the recovery in office-using employment remaining concentrated in a few key industries, do not expect the composition of office properties that are trading to change much in the near-term. That will mean continued downward pressure on cap rates over the next few years, at a minimum. And as the economy heats up, the office sector will become a more favored property type by investors.



Retail Cap Rate Trends

The mean retail cap rate during the second quarter was largely unchanged, hovering around 8%. The mean cap rate has skipped off the bottom that it reached during the fourth quarter of last year. This marks a reversal of the trend in retail cap rates since they began recovering in mid-2010. However, a note of caution is necessary – yes cap rates are up a bit but only over the last two quarters and we have seen this story before. There are numerous instances over the last couple of years when cap rates appeared to be heading upward, only to decline once again. Generally speaking, retail remains out of favor. That doesn’t mean that investors aren’t interested in compelling assets. However, due to the overbuilding that occurred in the decade before the financial crisis, many parts of the country are chronically oversupplied with high vacancy rates. This continues to force investors to be incredibly cautious and selective about doing retail deals. However, we mentioned earlier in this presentation that demand has been recovering, though masked by the overhang in supply. With construction for retail virtually nonexistent, the improvement in fundamentals will spur greater interest in the retail sector over time. An increasing number of properties will trade hands across a wider swath of the market. However, some submarkets and neighborhoods are likely to struggle for a long time, even as the overall market recovers. So be weary of the siren’s song of high cap rates – as I am fond of saying, high cap rates exist for reasons. Some of those reasons are cyclical and some are structural so be careful not to confuse the two. Some mistakes were built to last. It’s best to avoid those. But for those of you actively chasing yield and looking for diamonds in the rough, the retail sector offers the greatest abundance of those deals at the current juncture. Just be sure to thoroughly do your homework before proceeding. What does the future hold for retail cap rates? Well, they are likely headed downward again over the next few years with the economy and labor markets anticipated to continue their respective recoveries. Again, the environment is conducive to good opportunists, just be careful.





Market Trends

The priciest markets have incredibly low cap rates, with Dallas office registering a scant 3.2% cap rate. Almost all of the markets in the top five across the major sectors were 5% or less, demonstrating the premium that investors are willing to pay for what they feel are good-quality assets, irrespective of the markets. I don’t think that Richmond or Charleston is a new epicenter of retail in the United States, but clearly some investors found very compelling opportunities in those markets during the quarter. Markets at the bottom are still contending with very high cap rates, even marginally higher than what we saw last quarter with the 12-month rolling cap rates. One interesting note from the bottom, Detroit retail ranks among the bottom five markets this quarter. During the last couple of quarters, it was bafflingly in the top five markets. Though I mentioned that this was largely due to just a couple of small centers that had changed hands, it is nonetheless interesting to see that based on deals traded during the second quarter it ranks in the bottom five.

Obviously, mean cap rates are somewhat more volatile than the 12-month rolling cap rates, but using either metric we find that markets can frequently rise to the top or fall to the bottom on the backs of just one or two deals because of the shallow trading market. And in many markets the deals are of rather small size and value, which only exacerbates the volatility of which markets are high on the list and which are low on the list. This will abate over time as investors become increasingly more interested in the retail sector – more deals, more markets. For now, we should not expect much stability in these rankings, irrespective of which cap rate we examine, although that itself is useful information.




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I am a successful Commercial Investment Real Estate Broker in Arizona now for 20 years and I worked with banks and their commercial REO properties for 3 years. I am also a commercial landspecialist in Phoenix and a Landspecialist in Arizona.





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