Commercial property values at 25-year high

Inside Business - Jonathan Guion - 12 Sep 16

The price investors are willing to pay for commercial properties, based on the property’s income stream, is at the highest level it has been in 25 years.

Marcus & Millichap has recently provided a study of the trends of the capitalization rates for the six major property types over the last 25 years. This study indicates capitalization rates for commercial property sales are currently at the lowest level they have been for decades.

Capitalization rates are used as a comparative indicator of what investors are willing to pay for a property based on that property’s net operating income, or income stream. There is an inverse relationship between the capitalization rate and the property value such that, the lower the capitalization rate applied to the net operating income, the higher the price paid for the property.

The last time in recent history capitalization rates were this low was at the height of the market in 2006. As an example, the average capitalization rate for apartments in 2006 was 5.6 percent. Through the second quarter of 2016 the corresponding capitalization rate for apartments is at 5.3 percent. There is currently a strong investor appetite for apartments.

Back in 1996 the apartment capitalization rates were as high as 9.7 percent and between 2006 and 2016 they got as high as 7.4 percent.

Corresponding capitalization rates for other property types are in line with apartments. Multitenant retail and office buildings reached historic lows in 2006 at 7.1 and 6.9 percent, respectively. They are both at 7.1 percent through the second quarter of this year.

National averages for capitalization rates generally have ranged from as high as 11 percent down to today’s 5.3 percent. Certain property types in major markets with high quality tenants can command even more aggressive capitalization rates.

Historically low interest rates and the lack of return on other investment types drives investors to look for higher yields through real estate investments. When commercial properties can generate capitalization rates of five to seven percent with corresponding returns at eight percent or more, that looks very attractive compared to the other alternatives available in the financial markets.

The yields on real estate are good but, as with all things, there is a balance and part of the drawback of commercial property investing is that it is less liquid than other financial instruments. Your capital stays tied up for a longer period but the returns are higher.

As more buyers search for yields, competition for quality properties drives up prices and in turn pushes down capitalization rates. The good news is commercial properties are available at all levels and sizes, from large multimillion-dollar institutional properties all the way to a small free standing local building occupied by a single company. The capitalization rates will vary based on the quality of the property, as well as the quality of the tenant.

As capitalization rates get compressed, tenant quality is a bit of a forgotten aspect of the value of the cash flow stream. The more competition there is for properties, the more investors need to remember that the quality of the tenants matters.

If the tenants cannot pay the rent, the cash flow doesn’t exist. A corresponding factor in looking at historic capitalization rates is that since 2006 there has also been a slide in base rental rates. Lower rents mean the net operating income for the properties has gone down and this has the effect of also pushing down the property values.

The correlation and impact between the rent drops and the capitalization rates are a subject for a different article.

For reference, the national average capitalization rates for properties valued over $1 million through the second quarter of 2016 are: 5.3 percent for apartments, 6.1 percent for single tenant net-leased retail, 7.1 percent for multi-tenant retail, 7.1 percent for office, 7.2 percent for industrial and 8.5 percent for hotels.

The result of all of this is that for those considering selling a commercial property, now may be an excellent time to maximize the value of an investment. Make sure tenants and leases are strong, books are in good order and you understand the quality of your asset.

If you are looking for better yields on your investments, now may be a great time to look at commercial property as an alternative. Just be careful to understand the quality of property and the tenants that will be paying the rent and creating the income stream.