CAP RATE LIMBO – HOW LOW CAN YOU GO?
Prices for commercial properties continue to rise across the nation. This is causing a
corresponding slide in CAP* rates of return to surprising new lows. Meanwhile, there is a widespread feeling that greater economic risks are looming ahead. Why? Two obvious factors are the baffling presidential election and a probable hike in Federal lending rates before year-end. News Flash: A new Starbucks with a drive thru window still under construction in Meridian, Idaho outside Boise just hit the market. This 2,200-square-foot building is offered at $2,426,300 or about $1,100 per square foot at a CAP rate of 4.75 percent. Wow!
This is a new watermark for Idaho, which is considered a “tertiary” market behind two other classifications of size: primary (Los Angeles) and secondary (Seattle) markets. We have never seen such low CAP rates. Generally, prices are higher and rates of return lower in larger markets due to the perception that market risks are lower in populated areas. An average CAP rate for the northern Intermountain region three years ago was in the range of 7 to 7.5. Clearly, investors are “chasing yield” due to the historically low rates of return found today in other asset classes like stocks, bonds, and money market funds. As of this writing, the 10-year bond yield rate is 1.76 percent, according to the Wall Street Journal. By contrast, the S&P 500 market average on Oct. 13 was up 6.15 percent year to date. Of course there are many economic and social factors that impact financial markets beyond the overall health of the US economy. History shows that all free markets are cyclical. Traveling in tandem, both the residential and commercial real estate markets have experienced steady recovery and expansion since depths of the recession in 2008. Many of us in the brokerage field believe the steep climb in prices is beginning to level off. Henry George, the famous economist of the 1800s, advanced the theory that real estate cycles are about 18 years long. This has proved to be remarkably accurate over time. Where are we now? We’re about 10 years after the last peak and eight years past the deep, dark valley of the crash. If history repeats as predicted, we have another eight years of upside before the cycle peaks again and begins to slide toward recession. What does this mean for you? If you are a Seller, it’s certainly a good time to harvest equity by selling a property you have held for a number of years. Trouble is, you may face paying capital gains taxes unless you can find a 1031 replacement property at a good price. Try switching from a single tenant property to one with multiple tenants to obtain a better CAP rate and hedge vacancy risk. Otherwise, know that paying tax isn’t a shameful or unwise strategy. If you are a Buyer, first understand the risks inherent in leverage—basically the closer the CAP rate gets to your loan interest rate, there is a heightened risk that refinancing will impact your rate of return when your loan comes due and you need to refinance. Take a look at secondary and tertiary population areas where CAP rates are more favorable. Also, seek properties with strong tenants and longer leases. Even if the CAP rates aren’t stellar, your vacancy or late rent risks are greatly reduced. Finally, the single-tenant, net leased “trophy” properties are sporting the highest prices and the lowest rates of return—perhaps try a multi-tenant property with more obscure, but also more secure tenants. In short, we see no cause for market jitters today. But Henry George would caution that we could soon see signs of entering the Hypersupply phase in the market cycle, which is characterized by an excess of new construction and increasing vacancies. This is the first warning sign that a recession lies ahead within two to four years. Still, commercial real estate is certainly an asset class that is outperforming other investments without nerve-wracking volatility. And it’s hard to beat the tangibility of hard assets made of concrete, brick, and steel