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Cap Rate Analysis – Real Estate: October Update

Posted 2017-11-07 by Will Hickson

It may be time to set expectations for a higher cap rate! Investing in commercial real estate comes with risks as well as opportunity and you want to ensure you get an appropriate return on your investment. Our bi-monthly blog summarizes market yields at the end of the month to provide context for the likely range of cap rate for your real estate investment opportunity. If you’ve uncovered investments that exceed this range, you’re beating the market!

Market-based cap rates typically lie somewhere in the range shown below based on the risk profile of property investment against a range of financial assets. If you’re interested you can read the original article here.

Graph comparing risk and return

October Month End Yields

Yields on benchmark financial assets have risen since August, led by an increase in the 10 year Treasury yield, in anticipation of forthcoming interest rate rises at the Fed. That increase has fed through into pricing of other risk assets, with the yield on the O equity REIT increasing by a similar amount, and the asking rate on apartment conventional loans rising by 0.17%. Expectations that the Fed will raise rates in December and again in 2018 remain high and two or three rate hikes over the next year could substantially increase benchmark yields.

cap rates, capitalization rates, real estate

Note: Longer term risk assets (public and private equity returns) will be reviewed annually and thus will remain the same for the next few months.

As you evaluate new investment opportunities and the appropriate cap rate you should be seeking, here are a couple of things to consider:

  • further interest rate rises (or even just expectations of those) will put pressure on commercial and construction loan rates which will create upward pressure on cap rates. That’s going to exert downward pressure over time on property prices.
  • there are also some signals of potential economic pressure with the continuing flattening of the yield curve. I would call those signals amber rather than red right now, but from my reading, I see widespread sentiment that asset prices are high right now. No one likes to be the buyer at the top of the market!
cap rate, real estate, capitalization rate

Benchmark yields rising in recent months

Target cap rate for investors

Personally, I’m moderately risk averse in my own decision making, and I would be looking for some improvements in deals with the current signals in the market. Class A properties might still command a cap rate of around 5%, or a 20x valuation multiple on first-year net operating income, but for Class B and C properties I would be looking for more upside from the 7% level I suggested in my previous posting.

Of course, cap rates in more capital appreciation focused locations such as NYC will be tighter.

I expressed a personal opinion on cap rates above, but naturally data is better! Are you looking for independent sources of cap rates? Check out the data listings on dmi.io.

 

About the author
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Will Hickson

Will is a senior data executive with extensive experience across the spectrum of data management and analytics, and a deep understanding of what it takes to find, wrangle and incorporate data into your business decision making workflow. His previous roles include periods working at some of the world's most forward thinking firms, including Thomson Reuters and Bridgewater Associates, as analyst, data manager, data buyer, business owner amongst other roles. Will is a passionate data evangelist and happy to engage in a conversation anytime to talk about the opportunities and share war stories. When he's not got his geek hat on, you will find him on the tennis court or at the piano.