Buying a CRE asset at a sub-5% cap rate is like buying a tech stock at a 100-price earnings ratio.
Treasury rates are rising rapidly with the 10-Year treasury currently at 2.72% and up substantially from the pandemic low of .65% two years ago. A conundrum in this CRE market is that cap rates so far, have not increased to reflect the increase in the risk-free rate of the 10-Year Treasury note, which is used as the base rate for cap rates. Instead of rising, cap rates have compressed further, especially for apartment and industrial properties. In the “hot’ Sunbelt markets, many newer apartments are trading at sub-5% cap rates and industrial properties at sub-4% cap rates. To be blunt, buying a CRE asset at a sub-5% cap rate is like buying a tech stock at a 100-price earnings ratio. Investors may get away with this for a while, but it will eventually lead to lower returns and even a loss of equity.
The cap rate is the property’s net operating income divided by the purchase price or value. Another way to determine the cap rate is to use the cap rate formula, which is; the risk-free rate (10-Year Treasury rate) plus a risk premium (typically between 3% and 10% and in today’s pricey market I use 7%) less the growth rate in rents, which currently averages about 3.5% for apartments and industrial properties. The formula cap rate is then, 2.72% + 7% – 3.5% or 6.22%. This is an average cap rate and needs to be further adjusted for the location and property type but even for apartments and industrial properties, the average cap rates should be in the range of 5% to 6% and not at pricey rates of 3.5% to 4%. The key question is when will the market begin to balk at high selling prices and low cap rates? I believe that this is beginning to happen now. The first signs of this value adjustment will be deals falling through, when buyers cancel letters of intent or purchase contracts and deal activity, which has been at record levels, slows down considerably.
It usually takes CRE sellers about nine months to a year to adjust to the market price of their real estate properties. Many properties that will come on the market for sale during the next several months, will have asking cap rates of 4%-5% and it will take the sellers about a year to adjust those cap rates because of higher interest rates and buyers’ reluctance to pay the high asking price. Another important issue is the amount of money that CRE private equity, wealth managers and private REITs have to invest in the US. These sums are currently over $250 billion and many of these firms will continue to buy properties at low cap rates to “put the funds to work” instead of sitting on the sidelines until cap rates begin to rise. Many of these firms will lose or forfeit their capital if the funds are not invested within a one-to-three-year time period.
All CRE property owners will see their portfolios decline in value if the assets were purchased during the last few years. However, since many are private entities, instead of selling today, they will extend the holding period and enjoy higher rents and partner distributions. Public REITs that are “marked to market” daily will initially see their stocks drop due to these higher cap rates, but then stock prices will begin to increase as they are able to buy new properties at lower prices and higher returns.