Is a Bottom in Sight for Cap Rates?

Investors and commercial owners alike have watched cap rates drop ever lower over the past few years, along with a flurry of new record-setting sale prices. That activity has many people asking the same question: How long will these “good times” last?

Some industry observers are speculating that cap rates have already peaked, and when it comes to further gains in property values, this maturing market is definitely moving into the ninth inning. But is it time to start heading for the exits?

Commercial real estate values have seen a healthy rebound in recent years. Property sectors have bounced back across all markets and, on average, have risen another 20 percent above pre-recession levels, according to Green Street Advisors Inc. Some industry experts are predicting an end to that bull run. Green Street recently announced its 2016 real estate property forecast that calls for a drop in values between 0 to 5 percent in the coming year in every sector except for self-storage. That is the first time in six years that Green Street has published an expectation for a price decline. The firm attributes bearish signals coming out of the corporate bond market as well as the REIT market for its view that real estate is fairly expensive right now.

For the most part, cap rates are already at or near all-time lows across the board. That is due in large part to the market recovery, incredibly low interest rates and huge investor demand. In the office sector, for example, investment sales surpassed $110 billion during the first three quarters of the year, according to a Q3 2015 Office Outlook by JLL. In the third quarter, cap rates on office properties dipped another 10 basis points each for primary markets – now at 4.5% – and secondary metros at 5.3%. 

So, what does that mean for owners and occupiers of space? Certainly, it is a good time to sell property to capitalize on premium pricing. The challenge, however, is that most other owners recognize the record-high pricing, and are hesitant to pay top dollar. Some of this hesitancy is contributing to a significant private equity overhang.

The cap rate compression is also shifting more attention to operating fundamentals as a means to boost yields and cash flow. On that front, it appears that there is still plenty of room to run as the economy grows — operating fundamentals are healthy and rents are expected to continue outpacing inflation. In office, for example, the vacancy rate improved to 15.1% in third quarter, which is down 80 basis points compared to a year ago. Office rents during that same period rose 4.3%, which is the biggest annualized gain since the recovery started, according to JLL. 

Although it remains to be seen how rising interest rates will impact pricing and cap rates, landlords may have more pricing power to raise rents since rising rates generally reflect a strong economy. And, even if predictions are accurate and cap rates have hit bottom, values may not necessarily stall out along with them. Values could rise along with improving cash flow from occupancies and/or rent growth.

Simple supply and demand could also influence cap rates and property values in the coming year. Despite the fact that it has become more expensive, commercial real estate remains an attractive investment in the low interest rate environment. Buyer demand, especially among foreign investors targeting US assets, could keep the pressure on cap rate compression and push values higher.

Billy Fink
Billy Fink
Billy Fink is a former member of the VTS team.
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