Where are Cap Rates Headed?
By Terry Painter, Mortgage Banker, Author of: “The Encyclopedia of Commercial Real Estate Advice” Wiley Publishers
What Commercial Properties have Cap Rate Compression Today?
Cap rate compression means cap rates are coming down and commercial real estate values are going up. This has been occurring at a breakneck since the recovery phase of the Great Recession ended in 2012 and the expansion phase was well on its way. In January of 2022, the most popular commercial real estate for sale – we are talking about multifamily, self-storage and industrial properties held steady in the 4.50 to 5.70 cap rate range. What is clear is that these properties are holding on to the cap rate compression generated in 2021. The question is, can cap rates continue to hold, or will they come down?
I like to compare commercial property value to an elevator. All elevators go up and down and have a top floor. With recessions occurring on average every 6 years bringing prices down, and commercial property values usually caped by their net operating income, this effects the amount of cash buyers can put down, which should hold prices down. But in today’s low cap rate environment, it appears that the commercial properties mentioned above will continue to increase in value and more floors will be added for this symbolic elevator. This is primarily because of the laws of supply and demand, and as there is a shortage of these properties on the market they are going at insanely high prices.
What enables these prices to skyrocket? Well, for one thing more 1031 sellers were offered prices they could not refuse and have ploughed profits into overpriced replacement properties driving down cap rates. To compound this further, new ground up construction starts for these property types have been at a snail’s speed, or nonexistent since the corona pandemic started. Once there are more properties built, cap rates should level off or come down a bit.
What Commercial Properties have Cap Rate Expansion Today
Cap rate expansion means cap rates are going up and property value is coming down. It’s obvious that office, retail, and hospitality properties are in this group. With so many workers working remotely at home, many large office properties where largely empty during the pandemic. Although most of these businesses paid the rent, occupancy on many office properties fell to 85% or below. This labeled them as distressed bringing their property values down. Also, many tenants have been hesitant to sign long term leases, which created tenant roll over risk for lenders. This meant someone interested in buying an office property would have to put a lot more down and most likely have to use more expensive financing.
Retail properties were also hit hard by the pandemic. Many retail tenants were already hit hard by the trend to buy online and then their businesses were restricted by too few customers. The uncertainty in this sector created it so that many retail tenants – especially restaurants and apparel stores did not sign longer term leases, again creating tenant roll over risk. This has made it difficult for these properties to be financed and caused their values to come down and cap rates to rise.
Hotels, initially got hit very hard by the pandemic with so few people traveling. This caused operators to make special arrangements with their lenders and greatly increased lender risk. Hotels seem to always have a difficult time during recessions and we did have the corona virus recession. Although many larger hotel chains have shown good signs of recovery lenders are still scared to finance them. Smaller mom and pop operations are still struggling. The result has been, if they want to sell, their poor financials end up pushing the price down.
THE SHOCKING TRUTH ABOUT CAP RATE
“There must be some mistake” Rick, my client said to me. “How can my property only be worth $5.25 Million when the exact same property 4 miles away sold for $5.6 million last year.” In fact, he was right on. He had gotten the blue prints to build his new 36 unit multifamily complex from his brother-in-law who had built and sold the exact same design last year. Rick’s apartment complex to be built, and his brother-in-laws were both located in adjoining sub markets in North Dallas. Rick had recently applied for a construction loan and the appraiser stated the completed stabilized value for less than an identical sale. Now his construction loan would be $262,500 less because of the appraisal. How could this happen? Because of Cap Rate.
There Is An Inherent Conflict of Interest Over Cap Rate Between Appraisers and Lenders.
It is important to understand that capitalization rate is the foundation for supporting the purchase price in the sale of a commercial property. But it actually originates from the income approach in a commercial appraisal. For lenders, the income approach is king. Furthermore, appraisals are not an exact science. In fact, they are far from it. In my 21 years working as a commercial mortgage banker and loan broker, I have read hundreds of appraisals and have been shocked, amazed and sometimes amused by them. When an appraiser starts researching the data for their report they can either start with a blank slate – with no expectation for a value, or they can start with an expectation based on cap rate for a value and then do the research to support that value. Please understand, there are appraisers that have the highest integrity and genuinely research the facts to come up with unbiased, very accurate reports. But there are also appraisers (who are not going to like me for saying this) that start with where they think the lender will be happy and then bring in the data to support that number.
What I am saying is that there is often an inherent conflict of interest between many commercial appraisers and the lenders that hire them. This is simply because of one or more of the following:
- The appraiser wants to please the lender, not have their reports challenged by the lender and get hired again by the lender.
- Most lenders just do not feel safe making a loan based on a cap rate in a sub market that has recently gone down – increasing the property value and commercial appraisers certainly know this.
- Lenders do not like to be the first at something. I have even had some lenders tell me that they are going to underwrite the loan to a 7 cap even when it is obvious that recent sales comparables have supported a 6 cap. This means that even though they say they lend up to 75% of value, they might really only lend up to 70% of value. After all, lenders know that although it does not happen often - property values can go down. So there is an innate pressure for an appraiser to support the valuation that they know the lender will feel comfortable with.
There is an Inherent Conflict of Interest Over Cap Rate Between Commercial Realtors and the Property Values their Offering Memorandums Support.
Just as for appraisers, listing agents for a commercial property can have a conflict of interest in how they support the property values they show. This is obvious when you read through many offering memorandums and find that some of the conclusion of value is based on projected rather than actual numbers, and sales comparables that have a large disparity when compared to the subject property. This marketing can be misleading in that often the comparables are not like properties in age, quality of tenants, leases, amenities, and location. Again, there are commercial realtors that have great integrity and support their listed property values based on actual numbers and actual comparable sales.
To make this simple, this is essentially what the listing agent may do. In order to get the listing, they tell the seller that they can get them this great price which let’s say has the subject property selling for a 4.7 cap. Let’s say that like properties in this sub-market are actually selling for closer to a 6 cap. Of course, the lower the cap rate, the higher the property value. To start with they will sell the property based on its potential income, not it’s actual income. This immediately increases the net operating income and lowers the cap rate. Next, they will search for sales comparables in like properties that support this value.
MORE ON CAP RATE
Cap Rate stands for capitalization rate and is used in commercial property valuations. Cap Rate is simply the net operating income (income minus expenses) divided by the purchase price or appraised value.
The cap rate or also in full – capitalization rate – is one of the most important figures to understand if you are an investor or potential investor in commercial real estate investment property, or selling investment properties. The cap rate is something you should especially become familiar with if you are new to investment in commercial real estate property.
Why is the cap rate so important? Because commercial lenders, commercial realtors and commercial appraisers all use cap rates to accurately find a commercial property’s current value. And, you should too. After all, if you want to buy a commercial property, don’t you want to know its accurate current value?
So what is cap rate or capitalization rate? It is the net operating income divided by the purchase price or appraised value. It is also the rate of return you get on the property based on the income the property is earning. An income property investor can not accurately determine their rate of return on their investment without applying an accurate cap rate to the property.
The formula for figuring a cap rate is:
Net operating income/property value or purchase price X 100
You are looking at buying a multifamily property in Denton, Texas for $2 million. You are planning to pay for it in cash. You want to find out the annual percentage of interest you would be earning on this piece of property.
Let’s say that the multifamily property’s net operating income (subtract expenses from gross rents) is $180,000 annually. This means that you are earning 9 percent annual return on your investment. From the above formula $180,000/$2 million X 100 = 9 percent. This means it is a 9 cap. You would be earning 9 percent on your investment.
You also want to purchase a multifamily property in Los Angeles listed for $2 million and it has a cap rate of 5.5 percent. This gives you an annual earnings of $110,000 after taking off expenses and prior to looking at the cost of financing.
Many of our clients at Apartment Loan Store live in California where cap rates are very low and they purchase properties in locations like Texas, Oklahoma, or South Carolina, where they can get properties with a higher cap rate. They want a higher cap rate because the higher the cap rate, the greater amount of money is earned on your real estate investment.
However, there are customers of ours who want to buy 3 cap properties in costly locations like Santa Monica, California. They have a preference for nicer properties in expensive areas. One potential disadvantage of properties that are very high cap is that they can be in need of extensive repairs and could be in neighborhoods that have problems such as high crime, and poor upkeep.
The first thing commercial real estate lenders look at is the cap rate to see if there is accurate assessment of the value of the property. This is based upon market income as well as expenses for properties that are similar.
On the other hand commercial real estate realtors base pricing on market cap rates in that particular sub-market. They definitely do not want the property to have an appraisal that is less than the price of the property because it very well could mean the loss of a sale.
Three Approaches in a Commercial Appraisal
There are 3 approaches used in full commercial appraisals. The income approach is the most important and is based on cap rate.
1. The cost approach – based on what it would actually cost to build or replace the property today.
2. The sales comparable approach – based on like comparable sales.
3. The income approach – based on cap rate determined by rent, income and expenses on similar properties.
To get the final valuation, you take the average of both the sales comparable approach and the income approach.
Again, the basis of the income approach is the cap rate. Capitalization rate orginates from the sales comparable approach in commercial appraisals. There will be a comparison between 3 to 5 different similar properties that have sold, and the subject property. The way you get the final value of the income approach is to take an average of capitalization rates that the properties that were comparable were sold at.
By Terry Painter/President Apartment Loan Store and Business Loan Store