Is the Cap-Rate Valuation Model Still Valid?
Cap rates have been high for several quarters in a row. But is the cap-rate measure still valid to use when evaluating a CRE buy, especially in the multi-family and net-lease markets?
- Apr 04, 2012
By Bruce Davis,
Senior Partner, Lee and Associates Atlanta
As we slowly attempt to rise from the 2008 recession, commercial real estate has offered some tremendous opportunities — that is, if you bought at a deep discount with cash, and did so without forward-looking debt service. When someone recently mentioned the stock market’s return and approach to 14,000, I reminded him that the stock market is seen by those having current liquidity as the least scary place to park their money. CRE still has some ways to go, the bond market is still reeling from Obama’s outing of the bond holders in General Motors and foreign investment is a quandary because of the Greek debt crisis.
Cap rates, the inverse of which foretells the health of an economy, have certainly been high for several quarters in a row. In fact, uncertainties in the marketplace may have dictated that the measure “cap rate” is too pure or delicate a currency to be used at all. In fact, the smart money — hedge funds and the like — has been involved in studying, analyzing and buying extremely large pools of debt offered at frightening discount from lenders frantic to clean up their balance sheet. And some of these billion-dollar pools are being sold at 70 – 85 percent discount to face principal value. I know from personal experience that much of this must be long money, as inquiries to these bulk purchasers who bought in at 20 to 40 cents on the dollar have no interest in hearing about an exit at 55 to 75 cents. They apparently want to wait for full recovery.
No discussion of cap rates would be worthy without pointing out that first, it has been a horrible time to sell. The bulk of all sales for a dozen quarters have been either user-driven, i.e., where the building or the asset is needed for the utilization of space for an entity’s own needs, or a distress or lender-forced sale or REO. Market factors have dictated steep discounts. In the case of the office sector, all tenants have moved up a grade (wherein the nicest properties with highest-grade amenity packages are “A” or “A+”). This musical-chair effect, which includes relocations with up to two years remaining on their current lease obligations are moving in to new buildings or upgrades to take advantage of the landlord’s need for income to service, or attempt to service debt. This has left the older or less kept up assets (class “B” or lower) at the bottom of the heap with soft rent rolls or significant vacancies, particularly those with exposed weaknesses such as access and parking. Only in the trophy asset class have implied cap rates remained pertinent, whereas other sales have become blasphemed as “priced by the pound” or having “dollar per square foot” monikers when pricing has been described. Such a premium or trophy assets have attracted 6-plus plus percent capitalization rates, and it seems that that other asset-class pricings have fallen off the cliff. And don’t even think about contingencies for financing — it’s all cash at this level.
An asset class seen fully in favor, with dramatic rebound over the last three quarters has been rented multi-family. The apartment market has returned with fervor, and mid-rise to high-end garden — even failed condo high-rises, if the local municipality allows them — are able to create healthy to full occupancies at increased rental rates. The devastated single-family market, with many having lost their homes has reversed the age old expectations of steadily appreciating values, and left them also with burdensome tax bills. In reality, home values continue to drop in many markets. Homeownership for the first time in decades is not the cure-all; in fact for many it has become the nightmare. The desire to be in more amenitized urban environments, with a more mobile lifestyle afforded by leasing, has led many to prefer apartments as a first choice. Apartment developers have newly flourishing markets, stabile occupancies, and significantly upward trending rates in some locales — as much as 10 percent per year in some areas. Sites planned with superior features and key employer bases can win construction financing with 25 percent equity on hand. Well-located apartments in good shape can bring six percent cap rates if all dynamics are strong.
An active market for investment sales is also the smaller, single-tenant, primarily free-standing triple-net leased asset. Characterized by credit tenant users, many investors trade these deals like Monopoly money. We see strong activity for those who make this market, in the 7 – 9 percent cap-rate ranges, everything from Starbucks Coffee to CVS Pharmacy and Walgreens, national fast-food purveyors, branch banks, dollar stores and auto-parts outlets. Seen as safe and liquid, this market get be financed and sees brisk trading at present.