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Resilient Cap Rates Create Real Estate Investment Rift

Commercial real estate investment is caught in a self-fulfilling cycle. Cap rates remain largely unchanged amid an economic downturn. Stable cap rates mean asset valuation remains steady. Investors, looking for deals amid economic turmoil, want to see discounts. Not seeing those discounts, buyers back out, keeping transaction volume low and cap rates stable, restarting the entire process. The Bid-Ask spread in commercial real estate investing is now a chasm.  

When the United States went into lockdown this fall, real estate CFO’s buckled-in and held their breath. Experts predicted cap rates, loosely defined as the time it takes to make all your money back from an investment, would expand. The prospect of rising occupancy, delinquent payments, evictions and new deals loaded with concessions had investors chomping at the bit for assets on the rocks. Commercial property funds sprouted up by the dozens, raising close to $300 billion to take advantage of distressed deals, the Wall Street Journal reported. Despite all that money, few transactions have happened this year. Transaction volume was down an estimated 42 to 48 percent, according to Moody’s Analytics. 

Investors looking to “play offense” found owners playing serious defense. Occupancy has stabilized and commercial properties continue to generate revenue. As we approach the end of the year, cap rates look more resilient than ever. Valuations have hardly budged. 

For investors, those initial reservations have been hard to overcome, creating a disconnect between the real estate sector and investors. Tenant credit quality, length of remaining lease and building occupancy and other key metrics in discounted cash flow valuation analysis have become the most important issues for investors looking to capitalize on market conditions. 

The asymmetry has created a rift. A CBRE survey found that 61 percent of buyers are looking for discounts from pre-pandemic prices and only 9 percent of sellers willing to offer such discounts. Resilient cap rates are telling owners not to change the value of their assets but signs of economic struggle are signalling to buyers that values should be discounted. The disconnect is limiting transaction volume which in turn is stabilizing the cap rate. In the absence of closed deals, cap rate data isn’t as clear. Without new data to move the needle, cap rates will continue to remain stable. 

“There’s still a very attractive spread in real estate. Given we’ve had the biggest economic shock in 100 years, we’ve hardly had cap rates moving at all,” CBRE Global Chief Economist Richard Barkham told listeners on the firm’s Weekly Take podcast. “Cap rates have been kind of super resilient. If they’re super resilient in the point of a crisis, then they’re only going to trend down when that crisis alleviates.”

Even for office, moves in cap rates have been marginal compared to rates from the end of 2019. Most sectors reported increases or decreases in the 25 to 50 bps range. Retail and hotels were an exception, where cap rates are rapidly increasing. Net lease retail sales and cap rates are at their lowest point in a decade. Stabilized grocery-anchored centers are one of the only retail assets classes to have cap rates minimally impacted, showing why they’ve long been considered blue chips in any portfolio. Cap rates like these across most of the real estate sector would be cause for celebration if the outlook wasn’t so murky. Limited transaction volumes give analysts pause, questioning their conclusions because of a small sample size. As an investment class, real estate has benefited from macroeconomic policies. Equity markets have plenty of liquidity thanks to low rates and the Fed continues to buy mortgages and other bonds. Stable cap rates combined with a relatively low cost of debt limits cap rate expansion further. 

So far the sector has avoided waves of loan foreclosures and bankruptcies that would create the type of distressed assets investors are looking to cash in on. Commercial loans have a much lower LTV than in the residential sector, giving owners more options for favorable financing to make it through the literal and proverbial winter. Banks have preferred to give concessions rather than take possession and risk selling assets into the current stagnant market.  

In one corner stands sellers in the commercial real estate sector, valuing their buildings based on pre-pandemic levels and the prospect of a recovery. In the opposite corner, buyers are factoring in what they see as the ‘new’ normal, looking to invest in discounted assets that aren’t being offered. Two diametrically opposed foes in the room where the deals don’t happen. 

“It’s a tale of two worlds right now: you’ve got a national public health crisis putting downward pressure on hotel and retail asset prices,” JLL Chief Economic Ryan Severino said. “But even within those two sectors, you have high quality assets that are still posting steady if not increasing revenue metrics. It’s no surprise therefore that a large enough number of buyers and sellers have yet to come to an agreement about pricing.”

It’s unlikely buyers and sellers will come together any time soon. The prospect of widespread vaccines on the horizon means investment activity in the commercial real estate sector will likely return to pre-pandemic levels sometime before the end of 2021. Outside of the hotel and retail sectors, barring any large large scale foreclosures, discounts may never materialize. As the sector recovers, cap rates are expected to contract. Owners have once again planted themselves firmly in their long-term outlook. This time it looks like it will pay off.

Associate Editor
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