Recent declines in cap rates appear to be signaling a commercial real estate rebound, indicating improved investor expectations of price growth in the market, according to a report from San Francisco Federal Reserve Bank.
The cap rate measures the ratio of net operating income to the price of a property and serves as a rough approximation of expectations regarding return on a property investment.
It can also be looked at as the commercial real estate equivalent of the price/earnings ratio of a stock, according to the bank. ‘The rent/price ratio is largely a function of interest rates and expected increases in the property’s price,’ it said.
After declining from 2004 to 2007 as investor expectations for price appreciation rose, cap rates jumped in 2008. ‘During the financial crisis, CRE prices dropped about 40% and the market for financing CRE transactions was severely disrupted, resulting in very high CMBS (commercial mortgage-backed securities) yields,’ said economists Bart Hobijn and John Krainer in the report.
After the crisis, yields for top rated credits more or less returned to normal, they said. But since the summer of 2010, cap rates have dropped half a percentage point as high rated CMBS yields have risen about 30 basis points. A basis point is one hundredth of a percentage point.
‘The decline in cap rates despite the slight increase in interest rates suggests that investor expectations for CRE price appreciation have strengthened,’ the report added.
Thus, the behavior of cap rates indicates that the market has priced in a slight rebound in CRE prices. ‘This could reflect improved fundamentals, such as expectations that rents will increase, or improved investor sentiment, such as an ebbing of investor risk aversion,’ the report explained.
Price appreciation in Kansas City, Minneapolis, Salt Lake City and Austin, Texas, is expected to be about 2% higher than national trends would indicate, said Hobijn and Krainer.
