Everyone talks about commercial real estate values and valuation trends in terms of cap rates capitalization rates applied to net operating income to yield a value. Cap rates are a simplistic method of valuation in order to apply a cap rate to net operating income, the resultant value implies that the net operating income is flat and fixed over time like the yield on a bond. In fact, net operating income changes all the time due to fluctuations in both income and operating expenses associated with the property.
In terms of the accuracy and relevance of cap rates, the table to the right presents the components of a property's cash flow and its relevance to the four commercial "food groups:"
In the table, only the rent line affects net operating income, while the other four rows affect the property's cash flow below the net operating income line in a property cash-flow statement. The conclusion is therefore, that since cash outflows for tenant improvements, commissions and down time are the lowest for apartments, then a cap rate valuation is the most accurate for apartments and the least accurate for office. In fact, the only realistic method for office valuations is to employ a discounted cash flow analysis of the net cash flows from an office property. A computer modeling program such as Argus is very well suited to assist, but is also very subjective to the user's assumptions.
However, as a simple metric, cap rates can be used to compare different markets, different property types and different time periods which is the basis for this article.
Factors affecting cap rate movement
Entire real estate courses are taught on cap rate theory, but in general the main drivers affecting cap rates are:
* Market location of the property
* Constraints on property supply in the market
* Rent growth expectations
* Cost of financing
* Investor's return thresholds
Note that lease supply and demand are excluded from the above list. The greater the supply of space, generally the lower the rents, yielding a lower net operating income, and therefore a lower value. The converse is true of higher demand, especially when future supply is constrained.
The first three items above are often based on investor perceptions and can be strongly influenced by attitudes and the herd mentality. Foreign investors tend to concentrate on New York, D.C. and Los Angeles believing that they are the best locations in the United States thus driving up prices and lowering cap rates. In big cities like San Francisco there are constraints on supply both physical (water on three sides) and artificial (anti-growth ordinances). However, since the mid 1990s a huge amount of office square footage that had been devoted to mainframes and file cabinets has been freed up by major advances in computing power and storage capacity, both locally and in the cloud. Cap-rate compression is also rampant when buyers are willing to pay today for expected rent increases tomorrow apartments in Silicon Valley are a prime example.
The last two influencers are financial in nature. In a low interest environment such as today, investors can afford to buy at lower cap rates and still generate the returns they have promised their investors especially if investors can earn only 2 percent in dividends in the stock market or 0.02 percent on their savings at commercial banks.
Cap rates in northern Nevada history
My knowledge of cap rates in the northern Nevada market began 10 years ago when I entered the commercial real estate market after winding down the start-up that brought me here in 2000. In those days, cap rates were high, reflecting a combination of factors: Reno as a tertiary market, no real constraints on supply, modest rent growth expectations and investor expectation of higher returns in such a market.
As the dot-com stock market crash was winding down in 2003-04, investors were attracted to commercial real estate due to perceived higher returns. As the coastal markets heated up, investors came to our region expecting high cap rates . They were disappointed. With robust rent growth in the 2005-07 era, cap rates came down and prices soared in land and all investment real estate categories. Apartment cap rates came down from the low 9 percent range to 5.65 percent at the 2007 peak. Buyers in these times had interest-only loans to reduce their cash paid for debt service. They also had large expectations of future rent growth. Yet our cap rates were generally 2 percent above the major coastal markets of California, because we were still a tertiary market in all commercial property types except industrial.
Starting with the Bear Stearns real estate funds that collapsed in the late spring of 2007, culminating with the Lehman bankruptcy filing on Sept. 15, 2008, commercial transactions came to a grinding halt. No one knew what a cap rate should be on anything. There were no sellers and buyers who were bottom fishing, so a standoff ensued. Finally, as foreclosures started and lenders began slowly putting these properties back on the market, cap rates finally began to be measureable again. However there was a huge problem measuring net operating income, as the lenders generally did not have much operating history on "their" properties - and they generally were not stabilized so computing an net operating income was difficult. In apartments it was somewhat easier to derive a cap rate, as it was fairly straightforward to compute rents and operating expenses tended to be stable over time.
The current trend in cap rates
For the reasons described above, combined with the paucity of transactions, it has been difficult to quote cap rates in all commercial property types, with a slight exception being apartments. Believe it or not, apartments have had one for the highest rates of foreclosure, because apartments tended to be cash flow neutral to the special servicers. Net operating income fell to about 100 percent of the debt service. Also, as you recall from the chart earlier, apartments do not require large infusions of capital to re-lease them. Office properties, on the other hand, have seen many loan modifications and workouts, as the special servicers do not want to come out of pocket to fund the large sums of cash needed for office tenant improvements and commissions.
Our market has had a number of apartment sales out of foreclosures. Many observers are curious why cap rates today are about 2 full percentage points lower than when we started emerging from the dot-com bust eight years ago. Again, go back to the chart at the beginning of this article: investor's return expectations are low in this environment, and, with the 10-year Treasury under 2 percent, the cost of financing is low. While there are no major physical constraints on supply, vacancy in Class A apartments hover in the 5 percent range. Also the cost to build is such that there are only 900 units planned or approved in our market today. And everyone believes apartments are "THE" property type of choice due to demographics, lack of confidence (or financing) to buy a house, lack of long-term commitment to a job, a region, etc., and not wanting to lose everything like their parents, friends or neighbors did during the Great Recession.
So, in a word, cap rates are trending down. How fast? No one can tell. As long as the Fed keeps its low interest rate promise, low interest financing will keep cap rates low. Also "coastal" buyers are coming back to our market to pick up properties like Waterstone, Caviata, Waterford, Manzanita Gate, Delucchi Lane, and others.
Finally, tax policies in Washington will likely make dividends unattractive starting in 2013, and even with the 3.8 percent extra tax on real estate transactions, everyone needs a place to live, work and shop and they are not making any more land. All of this portends a relatively rosy picture for commercial real estate investment into the foreseeable future and they haven't put a FICA tax on real estate income yet.
Floyd Rowley, a certified public accountant who has earned CCIM designation, is senior vice president, investments, with the Johnson Group in Reno. Contact him through www.johnsongroup.net.
