Cap rates have an inverse relationship to property value. The lower the cap rate, the more valuable the property—and vice versa. Therefore, it is often said that a cap rate is the yield an investor is getting on the purchase price. The lower the cap rate, the higher the yield.
Another way to think about cap rates is that they are the inverse of an equity multiple. For example, a five-cap is said to be a 20 multiple on income.
Cap rates are influenced by the stability of the in-place cash flow as well as the projected growth of that cash flow. The interest rate environment, market conditions, and tenant profile can also impact cap rates.
In recent years, cap rates have come down in most markets and across most commercial real estate property types. In this article, we look at the impact of cap rate compression on CRE values.
What is cap rate compression?
Cap rate compression is when the cap rates for any specific property or property type come down.
At the building level, cap rate compression can occur after a property has been markedly improved, physically or operationally, or has a significant improvement in the tenancy. For example, if Apple, Google or the federal government signs a long-term lease for a Class A office building, it will likely trade at a lower cap rate than if it were leased to multiple office tenants with less impressive credit. Investors are willing to pay more for these properties given the perceived stability of the tenant.
Cap rate compression can also occur among all buildings of a certain property type within a specific geography. For example, when Amazon announced its “HQ2” in Crystal City, Virginia, investor interest in the area skyrocketed. Investors, buoyed by Amazon’s long-term investment in the region, started purchasing other office and multifamily buildings with rapid speed. The significant uptick in investor interest caused cap rate compression within the marketplace.
There’s been similar cap rate compression in the Tampa Bay, Florida office market. Investors who once focused on properties in Los Angeles, San Francisco and New York City have watched a growing number of workers relocated to Florida in the aftermath of COVID. Now, those investors are reallocating large swaths of their portfolios to Florida-based office buildings given the uptick in demand. As competition for Florida office buildings has increased, cap rates have correspondingly compressed.
Office cap rate compression
While cap rate compression impacts all real estate asset classes, it has specific impacts on the office sector.
The biggest distinction between office cap rate compression and other product types pertains to credit. For example, when someone is contemplating the purchase of a 300-unit apartment building, few buyers are going to dig into the credit of all 300 tenants renting units in that building. It will be assumed that the tenants met some preliminary screening criteria as part of the broader application process and therefore, have at least some minimum credit score.
In contrast, those looking to purchase an office building will generally look to see at least three years’ worth of an office tenant’s trailing financials, balance sheets and cash flow statements. They will also ask to see any projections that the office tenants have relative to their future income and expenses. Prospective buyers might even look for news stories or undertake other investigative measures to understand the stability of an office tenant. Investors spend significantly more time evaluating the credit of office tenants than they do the tenants of residential buildings.
The stringent due diligence on office tenants’ creditworthiness is because office tenants tend to be on long-term leases. Depending on the size of the property, the building may be leased to one or just a few office tenants. If one of those tenants stops making their rent payments, or worse, goes bankrupt, then the landlord could experience a significant disruption in their cash flow. An investor who has purchased a property at the height of the market, in a tight cap rate environment, will likely need that income to remain solvent.
Conversely, the creditworthiness of office tenants can impact a building’s cap rate. Tenants that are S&P or otherwise formally rated are considered the “safest” tenants and therefore, landlords can usually command prices for these properties. A building with highly-rated tenants, especially if those tenants are on long-term leases, will generally trade for lower cap rates than a building leased to tenants with more questionable credit.
Each prospective buyer evaluates tenants’ creditworthiness differently, and therefore, will make their own judgments about the tenants’ stability. This due diligence process is part art, part science. As such, two different buyers could come to different valuations (and therefore, different cap rates) based upon their assessment of the tenants’ creditworthiness – something that is decidedly unique in the office sector compared to multifamily investments.
Is cap rate compression good or bad?
Whether cap rate compression is good or bad depends on a person’s perspective and role in a commercial real estate deal. Sponsors with existing real estate will generally find cap rate compression to be a good thing as it makes their buildings and assets more valuable.
Cap rate compression can also lead to higher rents over time. For example, someone who purchases a property at the top of the market for a low cap rate may feel more pressure to fully stabilize a property and increase rents than if they had purchased the same building at a lower price and higher cap rate. Those who pay top dollar for a property naturally want to grow their yield as much as possible.
Conversely, from a tenant’s perspective, cap rate compression might be viewed as a bad thing if it results in higher rents. Unless tenants have other options, they may be forced to pay more for their leases than they would in a higher cap rate environment.
Ultimately, the extent to which cap rate compression has an impact on the local rents will depend on total supply and demand. If there is excess supply in a marketplace, cap rate compression will not have a major impact on rents. In a tighter tenant market where vacancies are low, cap rate compression could have a great impact on rents as landlords feel pressure to maximize their yields.
Interest rate compression
Interest rates are fundamental to the commercial real estate industry. Nearly all properties are purchased using some degree of leverage, to what extent can vary depending on the sponsor and their specific approach to leverage. Unlike residential properties that are purchased with mortgages close to 80 percent loan-to-value (LTV), most commercial properties utilize mortgages ranging anywhere from 50-70 percent LTV.
There are two types of debt that sponsors generally use to finance commercial real estate: fixed-rate debt and floating-rate debt. Most stabilized properties are purchased using long-term, fixed-rate debt.
Sponsors planning to undertake construction projects or other value-add deals will generally use floating-rate debt. This is because value-add projects are viewed as riskier than financing stabilized properties, and therefore, lenders view floating-rate debt as a way of mitigating their risk while a value-add strategy is being executed.
Interest rate compression therefore impacts cap rates in two ways.
First, lower interest rates on fixed-rate debt make it more affordable for sponsors to pay more for stabilized properties. This correspondingly results in cap rate compression. In a higher interest rate environment, property values tend to decline as interest payments become a more substantial factor in a deal’s economics. In some cases, a sponsor may be able to assign their fixed-rate debt to a new buyer which can preserve the property’s value.
Second, lower interest rates benefit those with floating-rate debt because it can cause total project costs to come down (though most floating-rate loans are written to have a minimum interest rate built in to protect the lender’s spread).
Cap rate reversion
One of the ways that sponsors value commercial real estate is by applying a discounted cash flow (DCF). A DCF analysis looks to project a property’s cash flow (monthly or annually) two, five or even ten years into the future. Then the sponsor applies a “discount rate” to each one of those years.
For example, the sponsor may apply an 8 percent discount rate. To do so, they will divide the first year cash flow by 1.08. The next year, if the same 8 percent discount rate is applied, the cash flow will be divided by 1.08 (squared) – i.e., a slightly larger discount in Year 2 than in Year 1. The sponsor will continue to do this over their intended hold period, however long that may be.
Sponsors use DCF analyses because, according to the “time value of money” economic principle, a dollar received today is more valuable than a dollar received in the future. Therefore, sponsors want to apply a discount to future cash flows. This also helps to control for opportunity costs. An investment made today is tied up during the hold period and cannot otherwise be invested.
At the very end of the hold period, the sponsor will sell or otherwise recapitalize the property. A DCF analysis will factor in this sale, as well as any growth in revenue achieved at that time (say Year 10 or 11). To find the value in that year, the sponsor will take that year’s projected cash flow, divided by an anticipated exit cap rate – otherwise referred to as a “reversion cap rate”. That sale price is also divided by the discount formula. The sponsor then takes the total sum of all of those individual discounted cash flows, adds them up, and is left with the property’s “net present value”.
The reversion cap rate is a way for a sponsor to calculate the net present value of a property based on all discounted cash flows, including a discounted sales price as projected into the future.
Of course, the downside to using a reversion cap rate is that few sponsors can accurately project what cap rates will be in the future – especially as far out as ten years from today. Calculating a reversion cap rate requires many assumptions. It is by no means a scientific process and yet, what a sponsor assumes as a reversion cap rate can have a material impact on valuation because a 100 basis point difference in cap rates (e.g., a 6 cap rate vs. a 5 cap rate) can translate into millions of dollars down the road.
What is the opposite of cap rate compression?
The opposite of cap rate compression is cap rate expansion, or cap rate “growth”. Cap rate expansion occurs when multiples are shrinking and yields are growing.
Cap rate expansion can occur for several reasons.
For example, there may be a perception in the market that an asset class has become ‘”riskier” for whatever reason. A good example of this is what happened to hospitality assets during the height of COVID. Given widespread travel restrictions, many hotel properties traded at higher cap rates given the unknowns associated with the future of the industry. Cap rate growth often occurs whenever there is a loss of faith in a particular market or asset type.
Cap rate expansion can also occur in a credit constrained environment. As interest rates rise, it becomes more expensive to finance commercial real estate. An uptick in financing costs can influence what someone is willing to pay for an asset and therefore, can adversely impact cap rates. In fact, interest rates and cap rates are two of the most closely correlated metrics in the commercial real estate industry.
Cap rate expansion can also happen at the building-level. For example, two office buildings located in the same market might trade for two significantly different cap rates. This is often a result of the physical building condition, operational performance and/or tenant profile.
What is a good cap rate?
Defining a “good” cap rate is largely dependent upon the market and property type.
For example, a fully stabilized multifamily apartment building located in a core, growing market like Tampa Bay, Florida may trade at a cap rate as low as 3 or 4 percent. That represents a significant delta between the cap rates office buildings trade for in the same market, which are currently closer to 5 or 6 percent. The cap rate differential between residential and office buildings in the same market shows that asset type has a major bearing on how investors look at any particular investment. It signals that investors are more bullish on the long-term success of multifamily projects in these markets than office projects in the same area for any variety of reasons.
Geography also influences what should be considered a “good” cap rate. For example, pre-Covid, it was common for office buildings in Manhattan to trade for 4 percent cap rates. In Florida, the top office buildings were trading for 6 or 7 percent cap rates. At the time, Manhattan office buildings were seen as “safer” investments than those in other urban areas.
There are many other factors that can influence cap rates, including the tenant profile. An office building leased to a highly-rated tenant on a long-term lease will generally trade for a lower cap rate than a building leased to tenants with a weaker credit profile.
There is a lot for investors to consider when using cap rates to evaluate a property. Specifically, they should be looking into what is driving the property’s cap rate, whether there is room to increase yields based on what they know about the property’s condition, and how shifting market dynamics will influence cap rates in both the short- and long-term.
Moreover, an investor will want to consider their own risk tolerance. Purchasing a property at a lower cap rate might be a better option for a risk-adverse investor compared to one being sold at a higher cap rate in but need of more extensive physical or operational improvements prior to stabilization.
For several years now, cap rates have been on the decline. However, with talk of interest rates rising, there is reason for investors to expect cap rate compression to slow – if not reverse itself – in the months and years to come. Cap rate compression is something that Feldman Equities watches closely, as should anyone considering a commercial real estate investment.
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