Declining Cap Rates Appear to be Flattening

Capital markets continue on a slow, uninspiring recovery. Pricing keeps improving, but only for the narrow slice of the market where trades can clear. Across the Apartment, Office and Retail sectors, cap rates have been declining over the last few years, but they appear to be flattening now as the pricing on very high-quality assets has become quite rich. In this post we’ll examine cap rate trends for each sector in the context of each sector’s underlining property fundaments.

Apartment Cap Rate Trends

The mean cap rate, calculated on a dollar-weighted basis by quarter and illustrated by the blue line in the chart presented below, has been falling since the third quarter of 2009 and now stands at 6.3%, proceeding to inch its way toward rates last observed at the beginning of the recession in mid-2007.

We have seen declining cap rates fueled by a variety of key factors such as declining interest rates, risk-aversion in the wake of the recession with investors training their sights on what they perceive to be a less-risky property type, and the improvement in property fundamentals, especially in the apartment sector. With the sale of high-quality assets dominating the marketplace, this has fueled the ongoing disconnect in pricing between buyers and sellers, preventing many assets that are not of the highest quality from trading. With sellers taking their cues from current market statistics, they are being relatively aggressive regarding the prices that they are willing to accept to consummate a transaction. However, frustrated buyers feel that many assets should not command the same premium that the highest-quality assets currently command in the market and consequently buyers are unwilling to pay such vertiginous prices. In the apartment sector, this is increasingly translating into a willingness to develop apartment properties rather than pay prices that many feel are unreasonable. Sellers, on the other hand, appear content to hold onto properties until they can receive better pricing in the market.

Office Cap Rate Trends

The mean cap rate for office properties increased by seven basis points during the quarter to roughly 7.3%. As the graph indicates below, the mean office cap rate continues to be somewhat erratic. After compressing for most of 2010 and then expanding slightly during 2011, it has now increased for two consecutive quarters. But as we can see, the increase is very slight and is more indicative of a slowdown in cap rate compression than a reversal of the trend. To support this claim, we can examine evidence from the 12-month rolling cap rate. As the graph shows, the 12-month rolling cap rate appears to indicate that office cap rate compression has ceased, as it has been virtually unchanged for the last three quarters.

Like we saw with the apartment sector, investors could simply be easing off the gas pedal given the expensive pricing for high-quality assets than can actually trade. The key difference between the apartment and office sectors is that office fundamentals have not improved nearly as much as apartment fundamentals have. This means that low cap rates are not translating into much new construction activity.  With office fundamentals likely to continue to improve over the next few years, cap rates likely have further to fall, and certainly have further to fall before the rich pricing in the market serves as a catalyst for construction activity.

Retail Cap Rate Trends

After expanding by 100 basis points during the fourth quarter of 2011, it was virtually unchanged during the first quarter of 2012.  This places the mean cap rate just slightly below levels that were observed early last year. And despite the quarter-to-quarter unpredictability in the mean cap rate, if we examine the 12-month rolling cap rate, we can see that even within the retail sector cap rates appear to be leveling off.

The situation with retail cap rates is somewhat similar to the situation with office cap rates. Due to the ongoing selection bias in the marketplace (which greatly favors high-quality assets), strong demand, fueled by risk aversion and cheap debt, married to the relatively scarce supply of high-quality buildings for purchase, have conspired to cause cap rates to compress despite the uncertainty as to whether or not fundamentals in the sector have even stabilized. Even with investors believing that the highest-quality assets have become too expensive, development is simply not an alternative in this sector. Although interest rates are low, investors have little desire to pursue retail development deals while lenders remain incredibly risk averse and will only lend for retail construction and development when significant preleasing is in place. As one can imagine, with still weak fundamentals, sufficient preleasing is very difficult to obtain these days. Yet, like the office market, since fundamentals still have vast room for improvement, there exists the potential for cap rates to compress a bit further.