Future of CAP Rates

Posted by Donald Teel, Arizona Commercial

Commercial investors and real estate brokers/agents toss around the term “cap rate” as if it were some sort of tell-all with respect to commercial property value or the measurement of the strength of a commercial property investment.

Hold your horses!

Can a CAP rate determine a property value? Are CAPS an accurate measure of an investment? Can CAP rates be trusted as a true litmus test for investment?

Answer: No, no and no. In fact, CAP rate determinations are now coming under assault.

Brokers often convey value and pricing by dividing net operating income by a purchase amount, such as 125,000 (noi) divided by $1,125,000 (price) equals a cap rate of 11.1%.

CAP rates are simply the measurement of a property value for a given 12-month period “IF” the property were purchased “cash.” CAP rates are impacted when investors utilize financing and the terms of financing, such as interest rate, points, call date, etc., impact “true cap rate.”

Real World CAP Problems. What happens in a market where the actual or contemplated lease rates fall below levels suitable for so-called “adequate” cap rate?

Savvy investors know how important cash flow is and more importantly, how important predictable and sustainable cash flow is in a down market. Real world cap rate problems occur when the strength of rent rates is compromised by a struggling economy or by tenants who vacate properties due to their business failing to perform.

Example: If the prevailing and sustainable (emphasis on “sustainable”) market rents are anticipated to trend downward for more than 12 consequtive months due to a faltering national economy, cap rates may be a less than optimal way to determine purchase price value.

Welcome to today’s real world problem with cap rate valuation! I have a theory that the accelleration of tenant default has now become the single most powerful force in declining commercial property values. There goes sustainable NOI.

The Assault on CAP Rates. Shopping cap rates is usually a faulty initial premise in today’s market since most investors are unwilling or unable to park cash into 100% of the purchase price of a leased property.

Today, long term tenant performance is becoming less stable and the market competition for “exceptional” tenants is heating up. Vacancies are driving down NOI, lenders know this and are now adjusting their cap calculations to include historical property performance perdictions.

Cap rates as a tell-all financial apparatus are under assault and weighted calculations for financing and property segment performance MUST be taken into account by investors more than it has in the past.

A trustworthy cap rate will always be adjusted by the cost of money and the cost of alternative investments measured against real estate investment returns.

The strength of lease agreements, tenant performance, type of business and the cost of money over time (typically 3-5 years) are now more significant than ever.

Want more information about cap rates and the central and northern Arizona commercial markets? Email me or, if you prefer, call me toll free at 877-777-9100.

Allan Woodruff, CCIM

We’ve all been hearing  and reading “gloom and doom” from the media.

But we know from history that turning points come while the masses are still moaning about how bad things are.

So are we at a turning point? Are we close enough to jump back into the market?

Here are a few facts investors can consider in refining their commercial real estate investment strategies on either the buy or sell side:

1. The deleveraging process will take more time as we work through the process of restoring sanity to private and corporate finances. We’ve lived through a period of very high leverage which must be unwound.  Habits and attitudes must change as investors take a more realistic view on risk, increase savings and reduce spending.
2. Yes, there are economic “green shoots” being seen this spring. Witness the stock market rally and an upturn in existing single-family residential (SFR) real estate sales in February. Consumer Confidence rose slightly from March to April, according to the Conference Board. SFR affordability has reached a multi-year high due to collapsed prices and interest rates at their lowest levels since about 1971. The “transition point” (the inflection point at which prices fall slower than they had been) seems to have occurred in the SFR market, so there is evidence that SFR prices will find a bottom soon.  Prices are typically at early-2004 levels or lower.
3. In the commercial real estate, cap rates (net operating income divided by sales price) have been moving up. This has increased downward pressure on prices, and is a reflection of the higher vacancy factors and lower rents that many owners have encountered. “Commercial follows rooftops”, and the commercial market still has more workout time.
4. Multi-family has seen the largest increase in cap rates. This sector had previously held up best, while retail, office and other commercial sectors were impacted by the poor economy. 
5. Increasing commercial foreclosures will exert additional price pressure on all commercial sectors.
6. Markets tend to overshoot on the way up, and again on the way down. This provides investors a great opportunity to buy when “there’s blood in the streets” if they watch key metrics and turning points.

See the attached article, “Here Comes the Sun: The Recession May Be Over”, by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co, Inc.

In summary, commercial owners may still benefit from selling now, and re-entering the market at lower prices later. Buyers should be careful… make sure the project is solid, with conservative assumptions. The great financing now available can help make the project work.

Our REO Service is a great way for investors to buy at very attractive prices. If you are seeking commercial investment advice, please email me or, if you prefer, you may call me at (928) 830-2599.