CREbeat

Cap rates (for non CRE practitioners think inverse P/E ratio) have been trending up over the last year and half or so, meaning values are declining.  There was a time in 2006-2007 when “everything was a 6% cap” (at most!).  Quite a few seasoned real estate practitioners were scratching their heads wondering how this came to be and when it would end.  With the onset of the credit crisis in the late summer/fall of 2007 it became clear that the 6% cap era may be threatened.  As the recession has worn on, cap rates, as measured by the National Council of Real Estate Investment Fiduciaries and Real Capital Analytics, have generally risen by 75-100 basis points.  Now everyone is talking about the return of 8% and even 9% cap rates, which were the norm only a few years ago.  For perspective, the long term average for institutional quality real estate investment has been about 8.25%.  The consensus seems to be that we are headed back to that level, but we are clearly not there yet.

The lack of recent transactions may be holding the cap rate uptick somewhat in check.  Aside from investment property supply/demand and investor sentiment/expectations, the primary driver of capitalization rates is the cost of debt, i.e., interest rate levels (and other debt terms which have a material effect on leveraged returns such as loan to value ratios).  The expectation is that interest rates will rise, and cap rates will follow.  Interest rates are up a bit, but we have yet to see a significant increase in borrowing costs.  This is probably the primary reason that cap rates have not gone up as much as everyone thinks they have or will (yet, anyway).

It’s worth noting that if a property’s cap rate started at 6% at purchase and now stands at 7%, that’s a 17% drop in value based purely on cap rate movement and not considering any potentially lower net operating income, which has been common with the recessionary environment we are in.