Commercial Real Estate Offering 8%-9% Cap Rates, Anyone Interested?

One of the biggest changes in commercial real estate is the difference in cap rates*. Last year, REITs and developers were complaining about miniscule cap rates of 2-3% and lower. Now they’re finding significantly higher cap rates and lower values, but will buyers step up or dry up?

AIMCO’s Q308 conference call: (AIV)

According to data released this week by research firm Property and Portfolio Research, or PPR, NOI cap rates in the top 54 U.S. markets have increased from 4.8% to 5.8% since the late 2006 peak in values.

Absent NLI growth, this basis point increase would have resulted in a 20% decline in asset values. However, property NLI’s were up 7.8% during this period of time indicating that the net impact has been about a 10% decline in values. Our sale experience to date has been generally consistent with this data. Looking forward, PPR is projecting an additional 20 basis point increase in cap rates from the third to fourth quarter from 5.8% to 6%, which when offset by the expected increase in NOI is projected to result in a 3% decline in asset values. So a few observations. NOI cap rates are clearly turning up and values are declining.

Simon Property Group (SPG) said on its Q308 conference call in November:

The market is obviously much different than it was a year ago. The cap rate specifically is going to be very dependent upon the quality of the asset, but I think it's fair to say that cap rates are higher. Loan-to-values are lower and spreads are wider and we've clearly seen all three of those moves in that direction over the course of the last six to 12 months… Cap rates have moved up, say 9% to 9%

Kimco Realty Corp. (KIM) said the same on its Q308 call in November:

Some large investors however do have substantial funds available for large opportunistic purchases if cap rates continue to increase.

Investors Real Estate Trust's (IRET) FQ209 conference call:

We also closed on two multi-family loans, one a refinance and one a new loan, for total cash out of $11.0 million. Interest rates on these two multi-family loans were 6.26% and 6.38% fixed for 10 years.

In October IRET brought one previously unencumbered commercial building to market. We locked debt on a smaller medical office building in Kansas City at approximately 6.5%, fixed for 10 years, at 60% loan to value.

Lexington Realty Trust's (LXP) Q308 conference call:

Cap rates are going up to the extent we are selling properties at 8% to 9% cap rates.

Avalon Bay Communities' (AVB) Q308 conference call:

So far this year we have sold $600 million of assets, including $350 million just this quarter. As the year progress, cap rates are moving up and the general sales environment got much more difficult. The fact that we are able to get this volume of sales done at a weighted average cap rate of approximately 5.1% is a reflection on the quality of our assets that continue track (inaudible) of our markets and the fact that we got started early in the year.

Parkway Properties Inc.'s 2009 earnings outlook call: (PKY)

Cap rates have moved up a good bit since the October meltdown in the REIT markets; the implied cap rates have jumped up to 9%, 10%, in some cases 11% out there. I think it’s probably a little oversold is my personal gut feel on it but nevertheless if the REITs which are only 10% of the overall commercial income producing property in America, if that’s a correct window to the world then that’s sort of what the REITs are telling the world is the valuation of real estate today. Will the private market win out on that or will the public market win out on that? I guess that’s one of those things that’s a little less clear today.

*Cap rates as defined by Answers.com's business encyclopedia:

A measure of the ratio between the net operating income produced by an asset (usually real estate) and its capital cost (the original price paid to buy the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows: Annual net operating income / cost (or value) = Capitalization Rate

Comments

[malach hamo...:]

Higher cap rates are reflective of lowered expectations for growth in the underlying property revenue streams. Heading into an indeterminate recession it may not be realistic to assume that an Avalon Bay can roll over rents at higher rates, or that a Simon Properties can keep its inline stores occupied by profitable retailers.

Those who differ are invited to buy these stocks at "bargain prices".

2008 Dec 18 06:10 AM

[joey balls:]

What does NLI stand for?

i.e. "Absent NLI growth, this basis point increase would have resulted in a 20% decline in asset values."

help!

2008 Dec 18 08:56 AM

[double beta:]

I belive NLI is Net Lease Income. Could also be called 'Effective Gross Income', especially if you are adjusting for hypothetical vacancy rates.

2008 Dec 18 11:03 AM

[billddrummer:]

NLI and EGI are identical. Both include adjustments for vacancies and credit losses, nonreimbursed property operating expenses, and provide a basis for determining cap rates, debt coverage ratios, cash on cash return, and property values based on both the actual and potential income streams.

2008 Dec 18 11:33 AM

[joey balls:]

Thanks - that makes much more sense than anything else I googled.

2008 Dec 18 12:52 PM

[oldman:]

Please explain what this means.
Cap rates are going up to the extent we are selling properties at 8% to 9% cap rates.

2008 Dec 19 10:56 AM

[billddrummer:]

Hi Judy,

Thanks for this thread, excellent information!

The capitalization rate (cap rate) is a method for determining a property's value by discounting the income stream the property produces by a percentage. To compute a value, you take the income stream and divide it by the cap rate.

Here's an example. If a property generates $50,000 in annual income, and the cap rate is 4%, then the property's value based on the income stream is $50,000/4%, or $1,250,000. If the cap rate moves to 8%, then the property's value drops to $625,000 ($50,000/8%).

The comment above refers to the reality of the marketplace, where cap rates are rising because comparable sales are falling. Usually the cap rate is just a 'check' on a property's value--the biggest influence on value is what comparable properties sell for. So to generate demand, prices are falling, which pushes up cap rates if the income stream remains stable.

Cap rates can also change if the cash stream changes. In the example above, if the property generates $45,000 annually instead of $50,000, to get to a $1,250,000 value would require a cap rate of 3.6%--an extremely aggressive valuation. With softness in the commercial real estate market for virtually all property classes (industrial, retail, office, and special purpose), there's little incentive to overpay for a weaker income stream.

ATB,

Bill

2008 Dec 22 06:29 PM

[relmor:]

Rents are determined by a percentage of what you take in....Its one of your biggest expenses...The larger the company, the more space, etc... means more rent...usually...
Being such, as companies revenues drop, or new ones sign new leases at newer lower rates(of course, everyone can see all the space for lease signs, no one cares what the owners property taxes are..etc...) then you have less income. In fact, compounded, you have a lot less income...Failures...Pr... taxes on properties going up too..not down...Ironically...
REITS are screwed basically....They need a bailout...But were do you draw the line? We will need to bail out everything at some point...Getting a bit ridiculous...Im sure the elite commerical banks can move into the market being vacated by smaller companies..

2008 Dec 28 04:38 PM