How Low Can They Go? Thoughts on Cap Rate Compression

24th August 2017

Cap Rates are one of the key metrics in commercial real estate investment analysis. In very simple terms, its the ratio of rent paid by your tenants, to the price/value of the building. An important barometer on the current state of the market, cap rates are inversely related to value. As the price/value goes up, the cap rate decreases. Falling prices infer the inverse is true.

In our post entitled Cap Rates and Property Valuation. Understanding the Variables. we shared that high demand and well located properties, consistently sought after by potential investors, tend to command a lower cap rate. Similarly, low cap rates are typically seen with commercial properties leased on a long term basis to strong tenants. Perhaps a nationally recognized retailer, a major financial institution, or perhaps a governmental agency or department. Investor risk in such situations is low, and a sales price reflective of a low cap rate would be expected.

Conversely, a property that is perhaps not as well located, not as well leased, or which may be classified as a specialty use property, would command a higher cap rate. They are perceived to involve higher owner/investor risk. Okay, so far so good.

What About Risk?

What does the recent, and seemingly on-going cap rate compression, tell us about risk?

Those schooled in appraisal and valuation methodology, the writer included, have long been taught that increases in property income are a major driver of value, and consequently of lower cap rates. Furthermore, cap rates reflect the risk free return plus a risk premium, less the growth in long term rental income.

So if rental income is stagnant, as it is in many locations, then would lower cap rates not infer that investors are repricing their attitude towards risk? Or are we mispricing risk in the market?

Can We Expect Longer Term Rental Growth?

The components which enter into an assessment of the relative risk of a real estate investment of course include financing costs. These costs are directly related to bond yields, as Government Bonds often are held to be the “risk free” investment alternative for institutional lenders. Bond yields are at historically low levels. So if cap rates are continuing to fall, have investors become immune to risk? Or are investors perhaps betting on longer term rental income growth?

I am starting to think that there is a continued bifurcation in the market. Off shore investors have a different take on “risk free” investing it seems. They are often larger players, likely have greater access to less expensive funding, and perhaps more importantly, have a longer term investment horizon.

The market does not however, differentiate between local and offshore buyers. Cap rates reflect buyer sentiment. In this increasingly global marketplace, domestic investors are of necessity on the same playing field with larger off shore investors. The result seemingly is a continued cap rate compression. By some accounts this reflects an absence of a risk premium, or at the very least, a difference of opinion as to what constitutes risk. And speaking about risk, the upside on interest rates is very real…..but that’s for another post.

 

Allan Jensen

Dominion Lending Centres – Accredited Mortgage Professional
Allan is part of DLC The Mortgage Source based in Ottawa, ON.

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