After a recent client event in New York,
I spent some time discussing the markets with KC Conway, chief
economist in the U.S. for Colliers. It turns out we’re hearing the same
question come up pretty frequently: What’s going on with cap rate compression?
(KC has been having similar conversations regarding cap rates with bank
regulators.)
Over the past 24 months, U.S. capitalization
rates for all income-producing property types have declined to levels never seen
before. Rate compression has been most pronounced in multifamily and
credit-tenant, net-leased properties, where rates have dipped below 4.0%. Cap
rate compression has been slower to occur in industrial real estate; however,
that’s changing rapidly as investors rotate out of multifamily, and look to
invest in the re-making of America’s supply-chain in response to growth in
e-commerce and the Panama Canal expansion.
The Historical
Perspective
As
this graphic shows, we’re clearly in uncharted waters. The long-term average cap
rate between 1965 and 2010 was 9.5%. After dropping to nearly 6.0% prior to the onset of the 2007-2009 financial crisis, cap rates rose sharply between
2008 and 2010 to 8.5%. This increase, around 200 basis points, eliminated
approximately 25 percent of commercial real estate values. During the
recession, increasing vacancy rates and declining rents caused another 20
percent decline in values, as indicated by the Moody’s Commercial Property
Price Index (CPPI).
 |
| Source: American Council of Life Insurers. |
All
told, roughly 45 percent of the value of commercial real estate was wiped
out from 2008 to 2010. But less than three years after the “Great Recession,”
commercial real estate values have rebounded. Institutional capital and
commercial real estate investors are pursuing income-producing real estate again,
and have bid average cap rates to a new historic low: under 6%. Why;
and what is behind this trend?
Many ascribe the trend to institutional investors’
ongoing search for yield, but of equal import is investor anxiety over Federal
Reserve monetary policy aimed at devaluing the U.S. dollar and re-inflating
asset prices out of the risk curve. With a 10-Year Treasury yield around 1.8% and
inflation near 2%, commercial real estate certainly seems more attractive--even
at a historically low 4% to 5% cap rate.
What about equities or stocks? Here
commercial real estate is increasingly attractive because of its relative
stability. With most major U.S. stock indices at near-record highs, and the
volatility in electronic trading that can move equity prices by as much as 5%
in a single day, commercial real estate is a consistent way to attain
cash-on-cash yield above 4% (and as high as 7% or 7.5% in secondary markets) without
the daily fluctuation in asset price.
But there could be more to this trend than just a search for yield. The approaching retirement of millions of baby-boomers may see investor goals shift toward cash flow and dividends, and away from long-term asset appreciation. Certainly low interest rates have also been a factor. Would multifamily cap rates be in the 4-5% range without cheap Freddie Mac and Fannie Mae debt?
The question is whether cap rates must necessarily spike as interest rates rise. With so much capital on the sidelines waiting to be invested, could the conventional wisdom of overleveraging--because equity is expensive and debt is cheap--be turned upside down in the next five years?
