Posted by Berno on August 01, 2006 at 16:27:33:
Thanks Patrick, great post! I always feel good when I read a post and come away smarter for having read it. It was good to get your opinions on what the near future will hold as well.
CAP Rate Compression - Posted by CIO
Posted by CIO on July 28, 2006 at 04:18:10:
I would like to discuss CAP rate compression.
What are the contributing factors?
What is correlation between increasing & decreasing CAP rates with respect to purchase prices of income producing real estate?
Re: CAP Rate Compression - Posted by Talani
Posted by Talani on August 03, 2006 at 11:18:13:
Please explain the connection between international flow of funds and cap rate?
Re: CAP Rate Compression - Posted by ray@lcorn
Posted by ray@lcorn on July 31, 2006 at 16:53:43:
CIO,
Patrick hit the nail on the head… cap rate compression is the direct result of more money than deals. It’s called compression because as prices increase the cap rate decreases, eventually approaching the “safe-rate” cost of capital represented by the 10-yr T-bond rate.
I wrote a two part article a few weeks ago (see http://www.real-estate-online.com/commercial-real-estate/article-menu.html) that touches on the intertwined effects of flush capital markets, investor demand and the fundamental performance of income producing real estate.
The reality is this… over the last ten years commercial real estate has become a very stable investment vehicle due to stable capital supply via REITs, securitized mortgages (CMBS), and huge amounts of private equity.
With stock market gyrations in early 2001, capital fled the securities markets looking for return. It found a very attractive home in ComRE, with cash flow, equity growth and tax benefits to boot. That shoved demand through the roof. As with anything, when demand outpaces supply, prices rise.
The question is whether the current cap rate levels are sustainable. That’s one of those things we can’t know until after something or nothing happens, and opinions are all over the board.
I personally expect to see some slight increases in caps (decrease in prices) as interest rates return to normal, but not by much, maybe a half-point on the average for Class A assets. Most reports indicate that rents are rising (in most sectors, see article referred to above) and expenses (sans energy) are steady.
Will improving fundamentals may offset higher interest rates? Maybe, but it’s hard to make generalizations because of local influences.
Will demand continue apace? Probably so. Given the recent swoon in the markets due to earnings confusion and rising rates, this is a lot like 1999. But ComRE is a proven investment type now, available to many, and in a multitude of forms that can be fit to any investor profile.
ray
Re: CAP Rate Compression - Posted by Patrick S. Lawson
Posted by Patrick S. Lawson on July 28, 2006 at 19:51:37:
Ahhhh man…Do we really have to go into macro economics on a Friday night?
lol.
Ok. Twist my arm…
I’m going to assume that since you are asking the question you already know what CAP Rate Compression is. For those that don’t, it’s quite simple. Think of a CAP Rate as the same thing as a P/E (Price to Earnings) Ratio in Stocks. As commercial real estate prices accelerate faster than market rents the CAP rate decreases (the P/E increases)…think Google.
What factors contribute to CAP Rates?
-Capital Markets.
-Underwriting Guidelines.
-International Flows of Funds.
-Inflation
-Federal Monetary Policy
Right now we are seeing CAP rates start to decrease in many markets. In my opinion this is largely due to many investors bailing out of some equity sectors and looking yield and stability. Investors can affect the commercial real estate market a couple of ways.
They can buy into commercial reits that buy up commercial properties. As we have witnessed in the residential side of real estate the more buyers you have in a market the higher prices go. As prices increase you generally see a decrease in yield.
Investors can also buy mortgage backed securities or other (high rated) bonds. The more investors who buy bonds the higher the bond price and since there is an inverse relationship between bond prices and yields you see bond yields decrease as prices rise. The more investors “buy up” these bonds the lower commercial rates go or at the very least they are stable. Again, as we’ve seen in residential real estate the more capital available (low cost loans) the more buyers and the more buyers you have the higher prices go.
Underwriting guidelines also play a big part in capital availability. In the last decade we have seen lenders get very lax with their guidelines… Think 90% LTV Stated. The easier lenders guidelines are the easier it is to put that lenders capital into the commercial real estate market.
Recently I and the lenders I work with have seen a trend where investors are selling their residential properties that have seen large amounts of appreciation and 1031’ing (exchanging them while paying deferring capital gains taxes) them into commercial properties in the Midwest with good cap rates. The more investors that do this the lower the cap rates.
It all boils down to this: The more money people throw at commercial real estate the lower the return on investment will be, i.e., you will see CAP Rate Compression.
While we are starting to see the compression of CAP Rates we are also seeing rents increase. Remember, it’s about acceleration. If rent rates accelerate faster than prices you see higher cap rates. Well guess what? In many parts of the country it costs 25%+ more to own a home (or build an office building,etc) than it does to rent. This means that rents will increase. Investors realize this and are entering the commercial markets, thus providing a counter balance.
I expect that in 2006/2007 we are going to see record foreclosure numbers, not because of “high rates” as they are still low and should not rise by more than another .50% max, but because of so many people that purchased homes with 100% Financing on an interest only ARM at 4.5%…not to mention the fact that the interest only payment at 4.5% was 45% of their gross monthly income. It’s not hard to do the math. When someone?s payment nearly doubles and their gross income increases have not even kept up with inflation their are big problems ahead…These are future renters.
I tend to get discombobulated at times. I think that I may have answered your question or I may be way off. I look forward to Ray?s response; he tends to much more succinct.
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