Determining Market CAP Rates
What is a market CAP Rate today? It certainly is hard to tell. I can remember, back in the late 90′s, making spreadsheets comparing CAP Rates of tenants based upon their net worth. We had a CAP range for $500M – $1B net worth tenants, $250M – $500M net worth, $100M – $250M net worth and so on. At the time there was a distinct correlation between a tenant’s net worth and CAP Rate. Then came the boom years of 2002 to 2007 and all underwriting went out the window. Franchisee single tenant fast food – slap a 5% CAP on it and send out the brochure. Someone will buy it. And they did.
Now we are in a recession and retail property prices are moving as fast as the stock market. It is almost impossible to accurately pinpoint a property’s value as there is no common motivation from the buyers in the marketplace. One buyer is yanking money out of stocks to buy something more “secure” while another is in a 1031 exchange having sold at a great price and is now watching as his purchasing power increase daily. Not to generalize too much, but yesterdays 5.00% – 5.50% CAP Rate single tenant properties are (or should be) trading between 6.25% – 7.25% CAP Rates, depending on the lease terms, strength of the tenant and location. Multi-tenant properties have been hit much harder. If you can find a buyer looking for a strip center, you will quickly find out that CAP Rates have risen between 175 – 300 basis points and are now trading in the 7.25% – 8.50% CAP Rate range. It is important to note the the properties that are actually trading seem to be B+ quality or better. Class B and lower properties, whether because of location or tenant strength, are basically sitting on the market with little to no activity, regardless of pricing. This is especially true of multi-tenant assets.
There is one tenant that seems to be bucking this trend: McDonald’s. I don’t mean to keep writing about McDonald’s and singing their praises but the real estate investment marketplace seems to think they can do no wrong. Just this week I heard of one McDonald’s ground lease selling for a 5.00% CAP Rate and another having just received 4 offers, all in the low 5.00% CAP Rate range. Why is this? Well, for starters, McDonald’s is a well run company with more operating cash flow than most any other retailer out there. Secondly, and more importantly in my opinion, is the perception that McDonald’s should command a premium as compared to other fast-food properties. From a traditional underwriting standpoint I would agree with this; however, from a practical perspective, it is hard to come up with many other reasons to justify the premium other than the financial strength of McDonald’s. Realistically, are the rental payments from Jack in the Box, Taco Bell, Del Taco, El Pollo Loco or any other corporate fast food operator inherently riskier than rental payments from McDonald’s? I don’t really think so. So why then is there a spread of 100 basis points or more for all other fast food properties? Again, it comes down to perception. McDonald’s is the gold standard by which all other fast food investment properties are measured. The fact that McDonald’s offerings are few and far between creates scarcity in the market and serves to drive down CAP Rates as well.
So now we know that McDonald’s investment opportunities are easy to price. How about the rest of the lot? Pricing a property correctly has not been more important in the last 10 years than it is now. Overpricing a property is the kiss of death as the offering will sit on the market languishing with little real activity and have the added detrimental impact of being perceived as undeliverable in the marketplace. A property sitting on the market for too long garners negative attention and is perceived as having problems, true or not.
Where do we go from here? Well, I believe that CAP Rates are going to continue to rise for a few reasons. First, financing is difficult to secure, forcing investors to buy smaller properties with more cash down. This will clearly drive CAP Rates up for larger properties. Second, there is quite a bit of cash sitting on the sidelines waiting for a signal to begin buying. I believe that signal will be when returns are on par with those of a decade or more ago – true 10% – 15% cash on cash returns (for larger multi-tenant properties). Prices will have to continue to come down until the crowd of investors jumps back in and starts buying again. From what I have seen, investors are being vary patient at the moment. Lastly, CAP Rates will continue to rise because of the distress in the marketplace. Desperate sellers and banks will need to unload property at a rapid rate creating an oversupply of inventory, much like we are currently witnessing in the residential market.
If you are contemplating a sale of your property, now is the time. Waiting will only cost you money. Now is the time to pull your chips off the table and live to fight another day. There will be great opportunity in the marketplace is short order and those with the cash to take advantage will be handsomely rewarded.
Very good assessment of CAP rates right now. Have you seen many investor interest down your way on Walgreens
There will always be strong interest in Walgreens as long as they remain as strong a company as they are. CAP rates are increasing for Walgreens though – at least 7%+ right now.
[...] A look at capitalization rates the past few months may leave you wondering where the value in your property has gone. Many property owners are sitting on properties that have lost 10 to 15 percent of their value in the past year. Chris Rodriguez of Retail Chatr stated it best in his recent article on Determining CAP Rates: [...]