Tag Archives: Tampa Bay Commercial Real Estate

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What You Should Know About The Cap Rate

What You Should Know About The Cap Rate

Sourced by Property Metrics

The capitalization rate is a fundamental concept in the commercial real estate industry. Yet, it is often misunderstood and sometimes incorrectly used. This post will take a deep dive into the concept of the cap rate, and also clear up some common misconceptions.

Cap Rate Definition

What is a cap rate? The capitalization rate, often just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.


Cap Rate Example

Let’s take an example of how a cap rate is commonly used. Suppose we are researching the recent sale of a Class A  office building with a stabilized Net Operating Income (NOI) of $1,000,000, and a sale price of $17,000,000. In the commercial real estate industry, it is common to say that this property sold at a 5.8% cap rate.

Intuition Behind the Cap Rate

What is the cap rate actually telling you?  One way to think about the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase.  In the above example, assuming the real estate proforma is accurate, an all cash investment of $17,000,000 would produce an annual return on investment of 5.8%. Another way to think about the cap rate is that it’s just the inverse of the price/earnings multiple.  Consider the following chart:


As shown above, cap rates and price/earnings multiples are inversely related.  In other words, as the cap rate goes up, the valuation multiple goes down.

When, and When Not, to Use a Cap Rate

The cap rate is a very common and useful ratio in the commercial real estate industry and it can be helpful in several scenarios.  For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties.  A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.

Another way cap rates can be helpful is when they form a trend.  If you’re looking at cap rate trends over the past few years in a particular sub-market then the trend can give you an indication of where that market is headed.  For instance, if cap rates are compressing that means values are being bid up and a market is heating up. Where are values likely to go next year?  Looking at historical cap rate data can quickly give you insight into the direction of valuations.

While cap rates are useful for quick back of the envelope calculations, it is important to note when cap rates should not be used. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation.

Components of the Cap Rate

What are the components of the cap rate and how can they be determined?  One way to think about the cap rate is that it’s a function of the risk free rate of return plus some risk premium.  In finance, the risk free rate is the theoretical rate of return of an investment with no risk of financial loss.  Of course in practice all investments carry even a small amount of risk. However, because U.S. bonds are considered to be very safe, the interest rate on a U.S. treasury bond is normally used as the risk-free rate. How can we use this concept to determine cap rates?

Suppose you have $10,000,000 to invest and 10-year treasury bonds are yielding 3% annually. This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks. What if you were presented with an opportunity to sell your treasuries and instead invest in a Class A office building with multiple tenants? A quick way to evaluate this potential investment property relative to your safe treasury investment is to compare the cap rate to the yield on the treasury bonds.

Suppose the acquisition cap rate on the investment property was 5%.  This means that the risk premium over the risk free rate is 2%.  This 2% risk premium reflects all of the additional risk you assume over and above the risk free treasuries, which takes into account factors such as:

  • Age of the property.
  • Credit worthiness of the tenants.
  • Diversity of the tenants.
  • Length of tenant leases in place.
  • Broader supply and demand fundamentals in the market for this particular asset class.
  • Underlying economic fundamentals of the region including population growth, employment growth, and inventory of comparable space on the market.

When you take all of these items and break them out, it’s easy to see their relationship to the risk free rate and the overall cap rate. It’s important to note that the actual percentages of each risk factor of a cap rate and ultimately the cap rate itself are subjective and depend on your own business judgement and experience.

Is cashing in your treasuries and investing in an office building at a 5% acquisition cap rate a good decision?  This of course depends on how risk averse you are.  An extra 2% yield on your investment may or may not be worth the additional risk inherent in the property. Perhaps you are able to secure favorable financing terms and using this leverage you could increase your return from 5% to 8%.  If you a more aggressive investor this might be appealing to you.  On the other hand, you might want the safety and security that treasuries provide, and a 3% yield is adequate compensation in exchange for this downside protection.

Band of Investment Method

The above risk free rate approach is not the only way to think about cap rates.  Another popular alternative approach to calculating the cap rate is to use the band of investment method.  This approach takes into account the return to both the lender and the equity investors in a deal. The band of investment formula is simply a weighted average of the return on debt and the required return on equity.  For example, suppose we can secure a loan at an  80% Loan to Value (LTV), amortized over 20 years at 6%.  This results in a mortgage constant of 0.0859.  Further suppose that the required return on equity is 15%.  This would result in a weighted average cap rate calculation of 9.87% (80%*8.59% + 20%*15%).

The Gordon Model

One other approach to calculating the cap rate worth mentioning is the Gordon Model. If you expect NOI to grow each year at some constant rate, then the Gordon Model can turn this constantly growing stream of cash flows into a simple cap rate approximation.  The Gordon Model is a concept traditionally used in finance to value a stock with dividend growth:


This formula solves for Value, given cash flow (CF), the discount rate (k), and a constant growth rate (g).  From the definition of the cap rate we know that Value = NOI/Cap. This means that the cap rate can be broken down into two components, k-g.  That is, the cap rate is simply the discount rate minus the growth rate.

How can we use this? Suppose we are looking at a building with an NOI of $100,000 and in our analysis we expect that the NOI will increase by 1% annually.  How can we determine the appropriate cap rate to use?  Using the Gordon Model, we can simply take our discount rate and subtract out the annual growth rate.  If our discount rate (usually the investor’s required rate of return) is 10%, then the appropriate cap rate to use in this example would be 9%, resulting in a valuation of $1,111,111.

The Gordon Model is a useful concept to know when evaluating properties with growing cash flows.  However, it’s not a one-size fits all solution and has several built in limitations.  For example, what if the growth rate equals the discount rate?  This would yield an infinite value, which of course in nonsensical. Alternatively, when the growth rate exceeds the discount rate, then the Gordon Model yields a negative valuation which is also a nonsensical result.

These built-in limitations don’t render the Gordon Model useless, but you do need to be aware of them.  Always make sure you understand the assumptions you are making in an analysis and whether they are reasonable or not.

The Many Layers of Valuation

Commercial real estate valuation is a multi-layered process and usually begins with simpler tools than the discounted cash flow analysis. The cap rate is one of these simpler tools that should be in your toolkit.  The cap rate can communicate a lot about a property quickly, but can also leave out many important factors in a valuation, most notably the impact of irregular cash flows.

The solution is to create a multi-period cash flow projection that takes into account these changes in cash flow, and ultimately run a discounted cash flow analysis to arrive at a more accurate valuation.

Selecting a Discount Rate For an Individual Investor

What You Should Know About the Discount Rate

September 27, 2013  By Rob Schmidt  Sourced by Property Metrics

The discount rate is one of the most frequently confused components of discounted cash flow analysis.  What exactly is the discount rate and how does it work? What discount rate should I use in my analysis? These are all important questions to ask, and this article will explain the answers in detail. Read on for a deep dive into the concept of the discount rate as it relates to valuation and discounted cash flow analysis.

Discount Rate Definition

What is the discount rate? The discount rate is the rate of return used in a discounted cash flow analysis to determine the present value of future cash flows.


In a discounted cash flow analysis, the sum of all future cash flows (C) over some holding period (N), is discounted back to the present using a rate of return (r). This rate of return (r) in the above formula is the discount rate.

Discount Rate Intuition

Most people immediately understand the concept of compound growth. If you invest $100,000 today and earn 10% annually, then your initial investment will grow to about $161,000 in 5 years. This happens because your initial investment is put to work and earns a dividend and/or appreciates in value over time.

When solving for the future value of money set aside today, we compound our investment at a particular rate of interest. When solving for the present value of future cash flows, the problem is one of discounting, rather than growing, and the required expected return acts as the discount rate. In other words, discounting is merely the inverse of growing.

Discount Rate Sensitivity

When it comes to discounted cash flow analysis, your choice of discount rate can dramatically change your valuation. Consider the following chart showing the sensitivity of net present value to changes in the discount rate:


As shown in the analysis above, the net present value for the given cash flows at a discount rate of 10% is equal to $0. This means that with an initial investment of exactly $1,000,000, this series of cash flows will yield exactly 10%. As the required discount rates moves higher than 10%, the investment becomes less valuable.

This happens because the higher the discount rate, the lower the initial investment needs to be in order to achieve the target yield. As you can see in the chart above, the selection of the discount rate can have a big impact on the discounted cash flow valuation. For more background on the net present value (NPV), check out the Intuition Behind IRR and NPV and NPV vs IRR.

Selecting a Discount Rate For an Individual Investor

Since the discount rate matters so much, how do you go about selecting the appropriate discount rate for an individual investor? Non-corporate or individual investors normally consider their opportunity cost of capital when determining the appropriate discount rate.

What is the opportunity cost of capital?  Simply put, it’s the rate of return the investor could earn in the marketplace on an investment of comparable size and risk. It’s the opportunity the investor would be giving up if he/she invested in the property or investment in question, thus the term “opportunity cost.”

For example, if you have $1,000,000 to invest, what are all of your available investment alternatives with similar risk profiles?  Whatever the yield is on all of these alternative opportunities is the appropriate discount rate to use.  Another way to think about this is that for an individual investor the discount rate is simply the individual investor’s required rate of return.

Selecting a Discount Rate For a Corporate Investor

Selecting the appropriate discount rate for a corporate investor is a bit more difficult. Corporations often use the Weighted Average Cost of Capital (WACC) when selecting a discount rate for financial decisions. Broadly speaking, a company’s assets are financed by either debt or equity.  A corporation can also use retained earnings,  which are the after-tax earnings not distributed to shareholders in the form of a dividend.

The WAAC is simply the weighted average of each of these sources of financing. This is also commonly called the “hurdle rate”, because for an enterprise to be profitable it has to earn a return greater than the cost of capital. In other words, it must cross over the “hurdle” in order to be profitable.

The debt portion of the capital structure is typically in the form of short-term unsecured notes provided by commercial banks, and long-term debt is usually provided by bond investors. The equity portion of the capital structure is normally in the form of preferred stock and common stock.  The interest paid on short and long term debt is deductible for tax purposes, whereas the dividends paid to shareholders is not.  Any after tax earning a corporation generates that is not paid out to investors is kept as retained earnings.

Consider the following example:


To find the before tax weight of each source of capital, you can simply multiply the percent of total figure for each source by the before tax cost of each source. For example, short-term debt comprises 10% of the total capital and has a cost of 3.75%. Multiplying these two figures together results in a before tax weight of 0.38%.

Completing this for each source of capital results in a total weighted average cost of capital of 6.80%. This is the appropriate discount rate to use for this corporate investor. Any investment that the company makes must at least achieve a 6.80% return in order to satisfy debt and equity investors.  Any return greater than 6.80% will create additional value for the shareholders.

Discount Rates and Historical Asset Class Returns

Another way to think about the discount rate is to look at historical asset returns for the investment in question. Consider the following chart showing historical asset returns between 1970-2010:


The above chart shows historical asset class returns for Treasury Bills, long-term U.S. government bonds, institutional-quality commercial real estate as measured by NCREIF, and stocks as measured by the S&P 500. Additionally, the chart breaks out the volatility and calculates the risk premium of each asset class over and above Treasury Bills, which are traditionally considered “risk-free” in finance.

As shown above, the risk premium on institutional quality commercial properties represented by the NCREIF index averaged 4.55 percent ( or 455 basis points). The risk premium on long- term bonds was 366 basis points, while the risk premium on stocks was the highest, at 596 basis points.

In finance, the total rate of return consists of two parts: the risk-free rate plus some risk premium (r + RP). For short-term investments, the traditional choice for the risk-free rate is the current T-Bill. However, because commercial real estate is a longer-term investment with an average holding period of 10 years, the appropriate risk-free rate is the average T-Bill rate expected over the investment horizon.

For a 10 year holding period, the 10-Year T-Bond would be an appropriate choice. As an aside, sometimes even the 10-Year T-Bond yield is adjusted downward to account for the “yield curve effect”, which is the additional risk premium already built into the T-Bond over and above the shorter term T-Bill yields.

If these historical risk premiums represent current expectations, then we can use the risk-free rate calculated, and add in the historical risk premium to determine the total expected return. For example, if the risk-free rate was determined to be 3%, then adding in the above 4.55% risk premium would suggest a total return expectation of 7.55% for institutional-quality commercial real estate.

Discount Rates and Expected Returns

Because what happened in the past is not a guarantee of what will happen in the future, it’s often useful to look at expected returns going forward. In addition to the historical returns discussed above, another approach to estimating the current expected total return is to simply ask investors what they expect.

Of course this is always easier said than done.  Most larger commercial brokerage firms collect data on these return expectations on a regular basis, as do some appraisers and lenders. Additionally, there are several commercial real estate research firms that survey investor preferences on a regular basis.  One of the most popular survey’s is the Korpacz survey. While expensive, this report is regularly used by institutional investors.

Relationship Between the Cap Rate and the Discount Rate

Because cap rate data is easier to obtain than investor IRR expectations, it’s also worth mentioning the relationship between the cap rate and the discount rate. You may recall the Gordon Model from our article on the cap rate:


This formula solves for Value, given cash flow (CF), the discount rate (k), and a constant growth rate (g).  From the definition of the cap rate we know that Value = NOI/Cap. This means that the cap rate can be broken down into two components, k-g.  That is, the cap rate is simply the discount rate minus the growth rate. Using some basic algebra we can of course re-arrange this handy equation and solve for the discount rate. This tells us that the discount rate is equal to the cap rate plus the growth rate.

Most medium and large brokerage firms issue quarterly market reports that include cap rates on recent transactions. Reporting cap rate data is much more common than reporting IRR expectations. This means you can estimate the appropriate discount rate based on current cap rates in your market.  Simply take the relevant cap rate and add in a reasonable growth estimate and you’ll have an approximate discount rate to use in your discounted cash flow analysis.

One limitation to this approach is that cap rate data is based on proforma net operating income, not cash flow before tax. To account for this difference it’s sometimes common to simply adjust the cap rate downward by 100-200 basis points.

The Discount Rate and Discounted Cash Flow Analysis

The discount rate is a crucial component of a discounted cash flow valuation. The discount rate can have a big impact on your valuation and there are many ways to think about the selection of discount rates. Hopefully this article has clarified and improved your thinking about the discount rate.

Ever Wonder What The Difference Is Between Rentable Square Feet versus Usable Square Feet

December 19, 2013 By Ben O’Grady
Sourced by: Property Metrics

One of the first steps in evaluating a commercial property is determining the total rentable square feet. While this might seem like a straightforward calculation, it unfortunately doesn’t always end up being so simple. This is particularly true for multi-tenant buildings. In this article we’ll go over how to calculate rentable square feet (RSF), usable square feet (USF), and the load factor, then we’ll tie it all together with a clear example.

Usable Square Feet

In a nutshell, usable square footage is the actual space you occupy from wall to wall. Usable square footage does not include common areas of a building such as lobbies, restrooms, stairwells, storage rooms, and shared hallways. For tenants leasing an entire floor or several floors, the usable square footage would include the hallways and restrooms exclusively serving their floor(s).

Rentable Square Feet

Rentable square footage is your usable square footage PLUS a portion of the building’s shared space. As mentioned above, shared space can be anything that is outside of your occupied space and is of benefit to you (lobbies, restrooms, hallways, etc). As a tenant in a commercial space, you pay for a portion of the shared space and thus your monthly rent is always calculated on RSF.

The increase in the the rentable square footage above your usable square footage is referred to variously as the “load factor,” “common area factor,” or “add-on factor.” This is generally in the 10-15% range and can be higher in some buildings. When evaluating commercial real estate space options, you’ll want to be aware of this factor so you know exactly what you’re getting and what you’re paying for.

How to Calculate Load Factor

Calculating the load factor is pretty straightforward. First, find out how much total floor area a building has. Then, subtract the shared square footage to determine the usable square footage. The owner or owner’s agent should be able to give you these numbers. Then divide the total floor space by the USF to get the load factor.

Rentable Square Feet Load Factor

Example: A 100,000 square foot building has 15,000 square feet of shared space. The usable square footage is 85,000 square feet. The load factor would be 1.176 (100,000 / 85,000). That would also be the same as saying the building has a load factor of 17.6%.

Rentable Square Feet vs Usable Square Feet Example

Let’s look at a quick scenario when comparing load factors and rentable square footage to see why it’s useful.

The situation
A tenant is looking at two different office spaces, both with 5,000 square feet of usable space and the exact same rental rates, but differing load factors.

Option A
The first suite has 5,000 usable square feet and has a 20% building load factor for an additional 1,000 sf (5000 x 20%) of rentable space. Thus, the rentable square feet is 6,000 square feet.

Option B
The second office has 5,000 usable square feet and a 15% load factor. The rentable square footage is 5,750 sf (5,000 x .15 = 750). Option B has less rentable square footage and thus would cost less per month for the same amount of usable space!

With the same rental rate, the tenant would pay more per month on his lease for Option A at 6,000 rentable square feet. However, one factor to consider is with higher load factors, are you getting better shared amenities that justify the cost? In some cases, a fancier lobby and shared kitchen area could be enough of a draw to justify the higher cost for the same amount of usable square footage.

As shown above, rentable square feet is not always so simple. To make matters worse, sometimes landlords will even fudge the load factor and USF numbers to the point where it becomes part of the negotiation process itself. As with all commercial real estate leases, always read the fine print so you understand exactly what you’re paying for and exactly what you’re getting in return.

The Impact of Millennials on Commercial Real Estate– A Look at Commercial Real Estate in 2014

Emerging Trends – A Look at Commercial Real Estate in 2014

Paraphrased from article by By Michael Bull, CCIM |

2014 should be another year of improvement across all commercial real estate sectors, according to the “Emerging Trends in Real Estate 2014” report conducted by PricewaterhouseCoopers (PwC) and the Urban Land Institute (ULI).

Produced for the last 35 years, Emerging Trends is one of the most anticipated and respected forecasts for U.S. real estate. Interesting not only for its analysis of past and current performance trends to forecast future results, the report also looks forward by interviewing 1,000 U.S. real estate executives, investors, developers and market experts about their plans and market predictions.

Answering the Interest Rate Question

“While we were doing our interviews from July through early October, interest rates were on everybody’s mind,” said Mitch Roschelle, partner and U.S. real estate advisory practice leader for PwC. “In 2010, 17.7 percent thought the real estate market would be good to excellent. In this year’s survey, 67.8 percent thought 2014 will be good to excellent, so that tells you that rates won’t chill the market.”

If net operating income growth remains on pace with an increase in the cost of capital, the market can digest a rise in interest rates, Roschelle said. Additionally, lenders indicated that underwriting standards are loosening and spreads are compressing because of the profitability of banks, he added.

Lending Environment

As the economy continues to improve, lenders are getting back in the real estate game, guests said. A significant amount of capital still flows into the multifamily sector, but there is also capital available for retail projects in secondary markets, said Andy Warren, director of real estate research for PwC.

“Lenders are beginning to expand what they are willing to look at in terms of deals,” he added. Regional banks have started to open up and contribute more to the lending environment, Warren said.

“CMBS will be a big story in 2014,” Roschelle affirmed. “In fact, it’s leading the list of lenders for 2014. The CMBS market lagged in the past, so that’s big.”

Looking ahead to 2015, shadow banking will be a big trend, Roschelle said. “Funds are aggregating capital and putting it out in the form of somewhat conventional financing for commercial real estate,” he said. “It’s going to be bigger and bigger in the months to come.”

Investors Bullish on Texas and Florida

While technology-driven markets such as San Francisco and San Jose, Calif., remain high on investors’ lists, Texas has emerged as an important investment target, Warren said. “Dallas, Houston, Austin and Fort Worth are all in the top 10 markets for investors,” he said. “If you add in San Antonio, which is in the top 20, you have all four major metro areas in Texas as top markets for this year.”

One notable change in the survey was the decline of investor interest in the nation’s capital. “Washington, D.C., continued to perform strongly during the downturn because the federal government held up. Now with the discussions about the fiscal cliff and budget ceiling, it’s beginning to have a blow-back effect on the local market,” Warren added.

The Impact of Millennials on Commercial Real Estate

“People between the ages of 15 and 29 years old represent 28.5 percent of the population, the single largest group,” Roschelle said. “Decisions about commercial real estate are going to be made around Millennials for years to come.”

“Apartments are the first thing that come to mind,” Warren said. Millennials are looking for apartments in an urban setting that foster a “live, work, play” environment. “This is having a huge impact on major cities.”

However, the impact of Millennials expands beyond the multifamily market. Office environments are being reconfigured into a more open floor plan in order to attract and retain Millennials, Warren added.

Retailers are following Millennials from suburban to urban markets, developing new store layouts that will work in urban areas. The industrial market has been impacted as well because online sales are up, which means fulfillment centers will continue to be created to meet this uptick in demand. “Millennials have touched much more than just apartments,” Warren said.


10 Tampa Bay places to watch in 2014

10 Tampa Bay places to watch in 2014 – By:Chris Wilkerson Deputy Editor-TBBJ

Sourced by Tampa Bay Business Journal

1. Hyde Park Village sold for $45 million in 2013 to WS Development in Boston. Expect to see the new owners begin to put their fingerprint on the retail and restaurant destination in 2014.

2. St. Petersburg’s iconic waterfront has been under the microscope of city planners and the Urban Land Institute is expected to present a final report in January 2014.

3. Florida State Fairgrounds’ governing board is considering developer pitches and could choose one this summer that would allow for some construction on the valuable land to help raise money to repair existing infrastructure.

4. Channelside Bay Plaza looked like it was on the road to recovery in 2013 when the Port of Tampa agreed to buy the property outright for $5.75 million and then see what could be done to reinvigorate it. A new lawsuit from Liberty Channelside LLC alleging that the port purposefully spiked Liberty’s offer on the plaza will likely delay any resolution at Channelside while the court considers the suit.

5. Nathan Benderson Park’s world-class rowing facility is complete and boosters already have booked national and international regattas in 2017 and 2018. The park’s management is working to fill the calendar between now and then to help show that the $40 million investment can pay economic impact dividends.

6. A well-rested piece of dirt on Westshore Boulevard just north of Gandy Boulevard that once was home of Georgetown Apartments has the potential to sell in 2014. It has been seen for years as one of the most valuable development parcels in the region. If it sells, how the parcel develops bears close watching for insights into current trends in commercial and residential real estate locally.

7. A proposed site for future Raymond James Financial Inc. expansion in Pasco County is worth watching in 2014. The company has an agreement to purchase 65 acres that could hold as many as six four-story office buildings, and the project has seemingly been slow to evolve.

8. Bill Edwards bought St. Petersburg’s defunct Baywalk downtown shopping center with dreams of bringing it back to life. It’s hard to argue that Baywalk is the center of his attention since he had to significantly scale down his Mortgage Investors Corp. in the face of new federal regulations and he just bought the Tampa Bay Rowdies. Edwards and his team have been methodical in its search for the right tenant mix with the hope of turning things around.

9. The Mall at University Town Center opens in October 2014 and will change Sarasota’s retail landscape. Several anchor department stores will leave other malls in the area for UTC.

10. The long-stalled Cypress Creek Town Center in Pasco County could be under construction as early as summer, 2014 – this time as an outlet mall, published reports show. Environmental litigation held up the project at State Road 56 and Interstate 75 for years. Simon Property Group could have the mall ready to open in summer 2015.

Market Analysis: “A Stronger Asset” from CCIM Institute

New sources of capital and increased demand have strengthened the commercial real estate market.
by William Hughes

The current economic landscape has assembled an array of factors to structurally change real estate investment standards. The intertwining of the U.S. and global economies, deeper integration of liability and equity markets, and the accelerated adoption of real estate investment trusts and commercial mortgage-backed securities as major components of the sector have all contributed to this evolution. Furthermore, increased access to a variety of capital sources, combined with a multitude of real estate investment vehicles, has resulted in real estate investment earning its place as a mainstream asset class.

For today’s real estate investor, advanced facts and figures, deeper liquidity, and a range of broad investment opportunities that reach beyond merely primary metros have all allowed the further mitigation of risk. As supply cycles continue their two-decade trend of stabilization, the sector remains less volatile as a whole. Convergence of these influences has refined the foundation for attractive real estate cost positioning, resulting generally in falling capitalization rates over the last 20 years.

Cap Rate Movement

Typically, cap rates are inclined to stay range-bound during economic inflection points, with a usual variance of between 100 and 130 basis points. Whereas the length and severity of the the 2009 Great Recession and the 2001 Recession were markedly different, the recovery trends of cap rate performance proved surprisingly similar.

During the peak of the financial crisis, cap rates expanded from 6.9 percent to 8.1 percent between 2007 and 2009 before making a remarkably accelerated recovery, especially given the depth of the recession, according to figures from Real Capital Analytics, CoStar, and Marcus & Millichap Research Services. While the annualized yield on the 10-year Treasury declined 280 basis points to 1.8 percent between 2002 and 2012, the mean annualized cap rate for all property types dropped 150 basis points. Since the end of 2012, the 10-year yield has abruptly expanded 100 basis points to 2.9 percent as of September 2013. In evaluation, the mean cap rate proved more steady, edging down only about 10 basis points to 7.2 percent. While a delayed effect is still a possibility, forecasting the potential magnitude requires deeper analysis.

Throughout the Great Recession, the Federal Reserve has held the federal funds rate to nearly zero while infusing huge volumes of capital into the financial markets. The expanded period of monetary easing and the absence of government-supported distress sales have boosted the national mortgage market. This paved the way for cap rates and real estate values to bounce back far more quickly than in previous recessions and well ahead of an actual operating recovery. The exception to this trend occurred in multifamily properties, which recovered even faster than the other sectors.

Whereas tough credit underwriting continues to be an obstacle for potential borrowers, the Federal Reserve’s accommodative policies aimed at reducing near-term interest rate risk have aided in the refinancing and restructuring of maturing and difficult loans. This has resulted in more capital entering real estate as a comparatively sound alternative to reduced yield bonds and volatile equity markets.

A Hybrid Investment

Since the market bottomed in 2009-10, commercial real estate investors have favored the greater certainty of top-tier markets and properties with proven cash flows, despite their generally lower yields; this focus on prime markets limited meaningful price recovery to coastal and urban core markets, until investor interest began to spread a year-and-a-half ago. With most gateway primary markets having substantially recovered, occupancy and rent growth momentum has expanded to late-recovery secondary and tertiary metros. These areas may garner higher yields and offer room for net operating income gains, but they also carry higher risk. Many of these areas face relatively higher overdevelopment threats, less consistent demand, and more shallow liquidity, all of which could affect investor exit strategies. Reflecting these trends, the maturing primary markets have faced slowing cap rate compression and even rate upticks. Conversely, cap rates in secondary markets have tightened, supported by stronger operational momentum and sales volume. Naturally, investor risk will depend in part upon a market’s position along the arc of the real estate cycle and the investment time horizon.

The hybrid nature of commercial real estate makes it a compelling investment option, with a bond-like cash flow component even during economic downturns, as well as an appreciation component that often acts as a hedge against inflation, considering that property owners benefit from increasing rents and property values when inflation rises. In addition, many long-term leases contain consumer price index rent increases, while shorter-term leases allow investors to quickly adjust to market rates.

Rising Interest Rates

A period of falling cap rates helps elevate returns via appreciation. Rising interest rates — reflecting stronger economic activity — generally exert upward pressure on cap rates, requiring an increased emphasis on income growth to offset slower appreciation and higher financing cost. However, healed and expanding credit markets, strong global investor demand for U.S. real estate, and continued recovery in property fundamentals will help counterbalance the magnitude of rising rates, and lend support to property values. Having already absorbed a significant increase in interest rates, further cap rate changes should tie less to speculation regarding Fed policy and correlate more with measurable economic performance.

Debt and equity markets should remain stable for the foreseeable future. However, the environment is not without risk, and near-term volatility should be expected. The pending appointment of a new Federal Reserve chief, looming debt ceiling discussions, geopolitical tensions in the Middle East, and the effects of sequestration and declines in federal spending will hamper economic growth.

In addition, changes in monetary policy always present a risk to the economy. In this light, the Fed has demonstrated considerable dexterity, and should gradually exit qualitative easing in an orderly manner by slowly decreasing bond purchases and letting some securities mature. The Federal Open Market Committee has issued interest rate guidance, stating that the federal funds will remain range-bound between 0 to .25 percent at least until mid-2015, underscoring that monetary tightening would begin only after an economic and employment recovery has been well established. The Fed also noted that the tightening process would occur at a more gradual pace than historical precedent. 

Surely, higher interest rates will impact investors across the board. As financing costs rise, so will investors’ required returns. At a minimum, increased financing costs will decay some of the cap rate arbitrage of buying into secondary and tertiary markets, or value-add and opportunistic assets. However, the stride of occupancy and lease growth is likely to exceed that of primary markets and core assets for the midterm outlook. Demand for all commercial real estate, sustained by the reinforcing economy, remains solid, and supply risks are negligible for most property types. As a result, performance profits and other components will considerably counteract the effect of rising interesting rates, at least for the near term.  William Hughes

National Flood Insurance Program Update

Posted November 22nd 2013

In 2012, the Biggert-Waters Flood Insurance Reform Act (“the Act”) was enacted. The goal of this legislation was to stabilize and revise the National Flood Insurance Program (NFIP). Provisions of the Act will roll out in stages, including some that have already occurred. On October 1, one portion of the Act went into effect which would require the Federal Emergency Management Agency (FEMA) to remove flood insurance subsidies for certain properties across the country.

Unfortunately, some of the flooding zones were inaccurately tagged so many areas are misrepresented on flood maps used by insurance companies. This has resulted in serious cause for concern by property owners because premiums increased at drastic rates without consistency among insurance providers. One of the Act’s co-authors, Representative Maxine Waters, says “inaccurate mapping” and “incomplete data [have] led to unreasonable and unimaginable increases in premiums.”

Although the Biggert-Waters Flood Insurance Reform Act significantly impacts flood hazard areas, the law poses great risk to property ownership. CCIM Institute is concerned with the significant rate increases impacting members who manage or own multifamily residential and commercial properties.

Legislation titled the “Homeowner Flood Insurance Affordability Act” (S. 1610 / H.R. 3370) has been introduced to address the exorbitant premium rate increases. The legislation would delay the rate increases sparked by the Biggert-Waters Act to allow FEMA time to provide accurate flood maps and to complete an affordability study that would look at the impact of the new rate structure.

The Affordability Act has garnered wide bipartisan support with H.R. 3370 having 138 cosponsors and the senate companion bill, S. 1610, having 23 cosponsors, as of November 21. 

If you have experienced significant rate increases since 2012, please contact the government affairs department at legislative-affairs@ccim.com.

– See more at: http://www.ccim.com/newscenter/323356/2013/11/22/national-flood-insurance-program-update#sthash.hnBZFxAL.dpuf