CRE 101: What is a Good Cap Rate? (Part 4)

Real estate investors commonly ask, ‘what is a good cap rate?’ What investors are really asking is, ‘what is a good return for this investment?’, or ‘if I took the cash flow of an asset without considering mortgage payments, divided that by the purchase price to achieve the capitalization rate (cap rate), what target return is desirable for a commercial real estate asset purchased with all cash?’. The answer, quite simply, is that there is no universal cap rate to target and it depends on several factors that impact the difference in cap rates between properties, as well as how one defines “good”(For purposes of this discussion, we will use the word “good” as a term to describe a favorable investment that one might choose to make). For those who are frustrated with an “it depends” response, the first place to look for guidance on potential cap rates for the purchase of an asset is the broker package where cap rates for comparable sales are listed. View this with some skepticism as the assets may be cherry-picked and may not be truly comparable. Additional sources for comparable cap rates are the research sites of well-known brokerages like CBRE, Marcus & Millichap, Colliers, and JLL which contain asset specific quarterly reports by region and/or city.¹

As described in the previous cap rate articles in this series, cap rates are only one metric to value commercial real estate and are best used to compare the average unlevered (i.e., no debt) return of similar types of stabilized assets in a market or submarket. The cap rate does not take into consideration mortgages, because mortgages are different from property to property. While impactful for a particular asset, mortgages will distort comparison of multiple assets all other factors being similar.

The following provides an overview of factors that might impact an investor’s determination of what a ‘good’ cap rate should be in any given market and asset:

Risk Profile: Returns on all investments, real estate and otherwise, directly correlate to risk. A treasury bond, which is guaranteed by the full faith and credit of the US Government and has one of the lowest risks of any investment, has a relatively low return. Alternatively, junk bonds, which have higher risk ratings and target much higher returns, have a greater chance of default (they are “junky”, after all). In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment’s return matches its perceived risk. For example, an investor may choose to purchase a Class A 98% occupied multifamily asset in San Francisco offered for sale at a 3% cap rate, which the investor deems is a “good” cap rate, or a Class C single tenant office in Richmond, Virginia which is being offered at a 100% occupancy at 8% as a “good” cap rate. Neither investor is wrong, they are reflecting a difference in risk profile and desire for lower risk and lower return or higher risk and higher return. Therefore, the question to ask yourself as a real estate investor is, “Does the cap rate reflect the risk I am willing to take, all things being considered?”

Time: Cap rates on investments also change over time depending upon the macro and micro-economic conditions of the national and local market and the timing of the valuation in the real estate market cycle. When the economy is going well, job growth and consumer confidence usually lead to increased consumer spending. Strong macroeconomic inputs impact everything in commercial real estate from the amount of capital available in the market to buy and finance properties, to the actual assets themselves – office (space to locate employees), industrial (space to hold the goods people want to buy), retail (space to buy the goods in the market) and multifamily (space for the employees to live). These are all usually positively impacted by a strong economy. Alternatively, if the economy isn’t doing well, commercial real estate tends to suffer downturns. Interest rates also are a leading economic indicator, and when interest rates rise it is an attempt to control inflation in a growing economy. This means that the cash flow from commercial properties can support less mortgage debt, and as a result buyers of commercial real estate who use leverage tend to make lower offers. While a rising interest rate environment is usually an indicator of a strong economy, when interest rates rise, prices for commercial real estate tend to initially cool, and cap rates tend to rise. A market’s cap rate will change over time depending on how the economy is doing, particularly the economy of the local market where jobs and spending are most impactful at the asset level. Of note, buyers may want to review the historic cap rates trends in a market to see if the current cap rates make sense in a historical context, i.e., does the buyer want to purchase an asset in a market where cap rates are lower than they have ever been in the past? Since markets are cyclical, they may want to consider that the cap rate may rise at some point in the future and depending upon the appreciation rate of the asset’s rents, they could be poised to see a reduction in the property’s value.

Asset Type: The type of asset also impacts whether a cap rate is “good” or not and is also directly tied to risk and historic performance. Multifamily assets tend to have low default rates and a greater amount of available capital due to government agencies (Fannie, Freddie, HUD) offering loans to support housing at affordable prices. As a result of this asset type’s strong performance, and the absolute need for people to have a place to live, multifamily assets tend to have lower cap rates when compared to other asset classes. Hotels are considered a riskier asset type as they have higher default rates and often underperform when the economy is not doing well (i.e. people don’t travel for work or go on vacation as much), or if the asset is in a market where there isn’t sufficient demand. Because hotels are viewed as a higher risk asset type, one could expect the cap rate to be higher and the price lower, than a multifamily asset in the same market of similar quality.

Asset Class: For each property type there are generally three “classes” that denote the level of finishes, the strength of tenants and number of amenities, which directly impacts the rents the property can command. A “Class A” property is the best quality of all of the asset classes, which means it commands the highest rents and the best “quality” tenants, from a creditworthiness and balance sheet standpoint. A “Class B” property is in the middle of the pack and receives average rents and average quality tenants. Finally, a “Class C” property is of the lowest quality property and therefore receives the lowest rents and tenants with low creditworthiness. Class A properties have the lowest cap rates and highest values, Class C properties have the highest cap rates and lowest values, and Class B properties have cap rates and values in between Class A and Class C. Once again, the cap rates reflect the risk – real and perceived – that an asset holds. It is important when considering whether a cap rate is “good”, to know and understand what class, or quality level, the asset is in order to compare to other assets in the appropriate comparative set.

Deferred Maintenance: The overall quality of an asset is also impacted by the extent of deferred maintenance. High deferred maintenance for an asset may require significant capital for it to receive market rents for its asset class. For instance, a Class B multifamily asset that has a 1980s vintage may be getting market rents but have a roof that needs replacement, at a cost of $500k. Another Class B multifamily asset in the same market has the same vintage but received a full renovation in the last 6 months and is just now starting to achieve market rents. The first asset appears to have a strong 12 months of operating history but has a big capital outlay ahead that is both expensive and may impact tenants and increase vacancy. On paper the second asset may look less desirable because the Net Operating Income appears low for the last 12 months, but it has no additional capital outlay going forward. Having a significant deferred maintenance line item, therefore, will impact how the asset’s cap rate is viewed by a prospective buyer. If both assets are selling for a 6% cap rate, it may be beneficial for the buyer to consider what the return on cost is (stabilized net operating income divided by the purchase price plus any improvements) when comparing the two investments to see which one is preferred.

Location: One of the most significant factors that impact a property’s cap rate is the location. The old adage in real estate is, the only thing that matters is “location, location, location.” This sentiment reflects the importance that location has on the value of an asset. A market like San Francisco² has more jobs, commerce, transportation, and overall economic strength and desirability than a market like Baton Rouge³. A market with more demand results in greater property values; i.e., the cap rates in San Francisco are much lower, and property values much higher, than in Baton Rouge.⁴

Lease Strength: The strength of a lease is determined by the terms of the lease, such as the length, rental rate, lease concessions, rent increases or escalations, default provisions, penalties for breach, obligations of the tenants (like paying for property taxes, insurance and maintenance), and the financial strength of the tenant. For example, an office building that has Google as a sole tenant providing a 5-year term with 3% annual rent escalations and a guarantee from the parent company has a very different risk profile than an office building that has 50 tenants, all month-to-month with small mom-and-pop lawyers, insurance and mortgage companies, and other similar service providers. Because of Google’s corporate balance sheet strength, it likely would have negotiated a lower rate per square foot, lower rent increases, and more attractive terms than the many smaller tenants would have. Because of Google’s financial strength, its lease may reflect an overall lower risk profile to a buyer than the building with many smaller, less financially secure tenants. Strong leases for any asset type – whether it is multifamily, retail, industrial or office – will impact the risk perception of the property and likely result in a lower cap rate, which translates to higher property value.

Available Capital: While not a factor that impacts the cap rate of a property, available capital is a consideration when determining what a “good” cap rate is for whether to buy a property or not. Buyers of commercial real estate should not, as a general rule, use debt or mortgages that are more expensive (higher overall cost of capital including origination fees and closing costs) than the stabilized cap rate of a property. If using debt to buy and renovate a property, it may make sense to utilize capital that costs more than the cap rate yield for a short period to renovate and refinance into lower cost debt or to sell the asset. However, if the stabilized cap rate of an asset is less than prevailing interest rates for the asset, the buyer should consider using more of their own capital and borrowing less, as the debt will dilute the property’s overall returns.

As illustrated above, there are many factors that can impact the cap rate for a particular asset at any given point in time. Determining whether a cap rate is “good” requires a review of that asset in comparison to sales of other like assets in the market at the time of purchase, a review of the cost of capital as well as alternative investments one could make, and an honest assessment of the investor’s overall risk profile and tolerance. Fortunately, there is plenty of publicly available data now available to determine whether the cap rate for a specific asset matches the risk-return of similar assets. After conducting the proper diligence and accounting for variations in the property relative to the comp set, it comes down to an individual’s personal preferences, goals, and risk tolerance to determine exactly what a “good” cap rate means.

Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.