In an uncertain time, where the only thing that seems to be constant is the unexpected, cap rates have remained surprisingly stable. The fair-market value of any asset is defined as, what a buyer and seller are willing to accept at any given period. The three rudimentary components of commercial real estate value—capitalization rate, current net operating income and projected net operating income —vary based on macro-economic circumstances: the profitability of leases with existing tenants and the likelihood and expense of acquiring new ones.
Unfortunately, as with many things during the age of Covid-19 is that at least two of these elements (current and projected NOI) are in danger, causing a break in investment interest for a large amount of commercial real estate assets. But there is good news: cap rates have remained fairly steady. CBRE’s just-released Cap Rate Survey Special Report indicates that cap rates for most industrial, multifamily and office assets have stayed at pre-COVID levels.
Jim Chappelow of Investopedia defines capitalization rate as:
A capped rate is an interest rate that is allowed to fluctuate, but which cannot surpass a stated interest cap. A capped rate loan issues a starting interest rate that is usually a specified spread above a benchmark rate…
How is this stability possible in such a hectic environment? For one, investment volume is particularly low due to a large disparity in buyer and seller anticipations. Around 84% of CBRE’s Cap Rate Survey participants say that sellers are reluctant to offer reductions, while they are expected by 61% of buyers. With close deals being scarce, the level of transparency into market cap rates is low.
While investment capacity remains passive, the amount of signed confidentiality agreements has increased greatly. This exhibits that equity capital markets are vast, which will offset much of the larger market risk and instability.
However, retail and hotel assets are less secure. You won’t find hotels on the CBRE survey mentioned, because the segment is just too unpredictable to correctly measure.
It can be contended that if projected NOI is stable or lower, there may be additional cap rate growth than what shows in the survey. Others may also debate that if there were more forced sales, there would likely be an upswing in cap rates. But a forced sale may not give an accurate depiction of a willing seller, and therefore does not correctly reveal fair-market value. Though there is legitimacy to both these points, it is expected that cap rate growth will be limited more in this phase than it was previously. This is mainly because of immense equity market liquidity and, perhaps more significantly, the Fed buying mortgage and other bonds. This has created more beneficial impact than in nearly seven years, which hinders rising pressure on cap rates.
Though in general commercial real estate values will decrease due to current and projected NOI hurdles, relative cap rate strength vs. previous cycles will offer some good news in an otherwise challenging market.