Commercial real estate investments can provide handsome rewards, but one of the most important steps an investor can take is to ensure the purchase price is appropriate for the opportunity. Valuation levels are high today, as they are across many investment markets. Investors chasing yield are driving down the opportunities for rates of return that have historically been achieved. If you believe we are close to a market top, this is an especially important question for you as you consider the cap rate to include in your valuation calculator.
In real estate valuation, the yield opportunity is commonly reflected in the capitalization rate (or cap rate), which is a simplified valuation metric for assessing an investment opportunity. The cap rate is the initial yield on an opportunity – in a world of zero inflation and constant income and costs through time, it is equivalent to the discount rate you would use in a full discounted cash flow model, and your expected return (IRR).
What is a good cap rate for commercial real estate?
There are many data points that are needed in valuing real estate, which I have covered in a previous blog. In particular, cap rates for investment properties can have some meaningful variation as a result of factors such as quality of the property, location and regional market variations. However if we look at cap rates in the context of overall return opportunities in the capital markets we can establish a rational ceiling for cap rates (i.e., the lowest rate you should receive).
The expected return on an investment is related to the level of risk the investor is prepared to accept, and so we can use this framework of return opportunities across capital markets to build our picture. Conceptually it looks like this:
Where the cap rate for commercial real estate investments should sit on this chart is an interesting question. I placed it between REIT yields and the overall S&P historical return for the following reasons:
- REIT yields provide you with CRE type exposure across a portfolio of risk. Diversification of investment brings risk down, so in assessing an individual investment opportunity you should expect a higher return.
- The equity market overall has exhibited higher volatility over its history than real estate, with peak to trough changes of up to 70%. Commercial real estate has shown less volatility on average, and is backed by a physical asset, which means an investor is accepting less risk compared to a stock market play.
Of course, you would have to be nuts to yield less than the risk free rate of return offered by treasury bonds. At the other end of the spectrum you may find private equity type returns on your real estate portfolio but as you do so, you are moving up the risk curve in one form or another.
To turn this picture into actual numbers we need to choose some benchmarks that we can refer to for different returns. I’ve chosen the following set of benchmarks:
The data above is based on values today (7/7/2017) sourced from various freely available websites such as Google Finance, and we learn the following things:
- Yields for REIT’s, loans and corporate bonds are highly compressed right now, an indication of the yield chasing currently happening in the market.
- An appropriate cap rate ceiling is probably around 5%, or a 20x valuation multiple on first year net operating income. Of course at this level, you have little cushion, not to mention the operational burden of running the property, so you’d probably be better off investing the money passively and avoiding the hassle!
- Construction loan rates in the 5.5% range are an indication of the minimum return you would have to yield for a viable leverage opportunity
- The long term S&P return of close to 10% reflects a reasonable benchmark as a floor for a cap rate. If you could achieve this sort of return, especially in today’s market, you’d be in great shape.
There’s art as well as science in coming up with an appropriate rate to pay in the current market, but you can see how the simple data analysis gives you some grounded facts to assess your own risk appetite and the sort of return you should be expecting.
Note that for markets where capital appreciation plays an important part in overall returns, the cap rate will be lower. Reaching even 6% in the New York City market would be a fine achievement!
On a final note, you also have to look at this data in the context of your opinion on the future market trajectory. The data we are using is historical data, not expected future returns. If you have strong conviction that the market is topping out right now, then what you are really believing is that future returns will be lower than history based on current valuations. Too much future value has been brought forward. In that situation the best thing you can do is most likely sit on your cash and wait for rates to normalize closer to historical norms.
If you want to get a richer set of data on actual cap rates achieved in the market, you can do that through a number of vendors, although only a few have data at any scale. You can explore those vendors on dmi Data Explorer, by searching on data type: ‘Financing Data’ and filtering on Commercial Real Estate.
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