On page 16, I share my thoughts on Cap Rates, and Commercial Real Estate Investment Analysis.
Cap Rates are one of the key metrics in commercial real estate investment analysis. In very simple terms, its the ratio of rent paid by your tenants, to the price/value of the building. An important barometer on the current state of the market, cap rates are inversely related to value. As the price/value goes up, the cap rate decreases. Falling prices infer the inverse is true.
In our post entitled Cap Rates and Property Valuation. Understanding the Variables. we shared that high demand and well located properties, consistently sought after by potential investors, tend to command a lower cap rate. Similarly, low cap rates are typically seen with commercial properties leased on a long term basis to strong tenants. Perhaps a nationally recognized retailer, a major financial institution, or perhaps a governmental agency or department. Investor risk in such situations is low, and a sales price reflective of a low cap rate would be expected.
Conversely, a property that is perhaps not as well located, not as well leased, or which may be classified as a specialty use property, would command a higher cap rate. They are perceived to involve higher owner/investor risk. Okay, so far so good.
What does the recent, and seemingly on-going cap rate compression, tell us about risk?
Those schooled in appraisal and valuation methodology, the writer included, have long been taught that increases in property income are a major driver of value, and consequently of lower cap rates. Furthermore, cap rates reflect the risk free return plus a risk premium, less the growth in long term rental income.
So if rental income is stagnant, as it is in many locations, then would lower cap rates not infer that investors are repricing their attitude towards risk? Or are we mispricing risk in the market?
The components which enter into an assessment of the relative risk of a real estate investment of course include financing costs. These costs are directly related to bond yields, as Government Bonds often are held to be the “risk free” investment alternative for institutional lenders. Bond yields are at historically low levels. So if cap rates are continuing to fall, have investors become immune to risk? Or are investors perhaps betting on longer term rental income growth?
I am starting to think that there is a continued bifurcation in the market. Off shore investors have a different take on “risk free” investing it seems. They are often larger players, likely have greater access to less expensive funding, and perhaps more importantly, have a longer term investment horizon.
The market does not however, differentiate between local and offshore buyers. Cap rates reflect buyer sentiment. In this increasingly global marketplace, domestic investors are of necessity on the same playing field with larger off shore investors. The result seemingly is a continued cap rate compression. By some accounts this reflects an absence of a risk premium, or at the very least, a difference of opinion as to what constitutes risk. And speaking about risk, the upside on interest rates is very real…..but that’s for another post.
The Q4 Cap Rate Update compiled by CBRE suggests that change was the operative word for Canada’s major real estate markets as 2016 drew to a close.
As we’ve grown accustomed to over the past year or two, real estate demand and prices continue to show growth in both Toronto and Vancouver. CBRE’s Canada Cap Rate Report Fourth Quarter 2016 summarizes these trends and reports that Toronto saw several large transactions reflective of sub 5% capitalization rates in several major asset classes.
Vancouver was a similar story. Office assets are trading at or below 4% cap rates. The real surprising story was that there were several apartment trades in the previously untouched 1.9% to 2.3% range. It’s hard not to think that this market will need to take a pause and catch it’s breath.
Real Estate activity in the two major Alberta markets at year end, was reflective of the increased and ongoing sense of economic uncertainty. Cap rates ended the year either stable or increasing in these two markets. Office markets were particular hard hit as leasing uncertainty/risk continues.
Flying under the radar perhaps, are indications of increased investor interest in hotel properties. Cap rates for both limited and full service hotels are stable or declining in all major markets. Undoubtedly our low dollar is an attraction for foreign visitors.
Cap Rate Update
The on-going segmentation within the commercial real estate market in Canada, is a phenomenon which continues to be reflected by buyer sentiment, country wide.
In its recently released Q1-2016-CBRE Canadian Cap Rates & Investment Insights Report, CBRE identifies that “cap rates have moved up slightly in energy-centric markets and down, selectively, in British Columbia and Ontario”.
Across Canada, cap rates in the four major asset classes are stable, or increasing marginally. There remain, not unexpectedly, distinct local market differences. Vancouver continues to show strength in its core office market, with mid to low 4% cap rate activity. Vancouver also demonstrates significantly lower cap rates in the industrial market, than other major Canadian centers.
In the east, the Kitchener Waterloo market is demonstrating strength in the multi-family market, buoyed no doubt by employment gains in the tech sector.
Not surprisingly, sales activity in the office markets in both Calgary and Edmonton, reflect cap rates 200 to 300 basis points higher than in Vancouver. The report also observes that in Calgary “the office market has fallen out of favour with investors and there have been no office trades since the beginning of 2015”. READ MORE