John Reeder of Real Property Alpha has written a post exploring the possibility of a company’s P/E ratio predicting CAP Rates. If you look at the chart below, the numbers don’t really seem to correlate to capitalization rates as I see the market.
| Company | P/E Ratio |
| Target | 9.21 |
| Wal-mart | 14.84 |
| Safeway | 8.06 |
| Kroger | 10.94 |
| Macy’s | 9.92 |
| J.C. Penny | 5.65 |
| P.F. Chang’s | 12.03 |
| Costco | 13.65 |
| AutoZone | 14.85 |
| The Limited | 9.92 |
| Ann Taylor | 9.38 |
| Abercrombie | 5.98 |
| New York & Co. | 7.09 |
| Burger King | 15.79 |
| McDonald’s | 13.51 |
| Nordstrom | 6.69 |
| Walgreens | 10.3 |
| CVS | 10.85 |
| The Gap | 7.58 |
| Average | 10.33 |
Three of the best companies on the list have P/E ratios on the higher end of the scale (Wal-mart: 14.84, Costco: 13.65 and McDonald’s: 13.51). It seems to me that there should be an inverse relationship between a company’s P/E ratio and the corresponding capitalization rate at which that particular tenant should trade. The higher the P/E ratio, the more expensive that company’s stock is. This means the market is willing to pay a premium for the shares due to a lower level of perceived risk. This is inversely related to capitalization rates as the lower the capitalization rate, the lower perceived risk is within the marketplace for that tenant as buyers are willing to accept a lower return for higher security.
This rings true today as the tenants that are trading at the best capitalization rates are those seen to be “recession proof”. Examples of tenants commanding strong capitalization rates as compared to the weaker competitors are McDonald’s and Walgreens. It seems you can’t go wrong buying the best of the best. The market certainly seems to think so, at least right now.
Where I do agree with Mr. Reeder is that capitalization rates are most definitely on the rise. Where will they stop? Who knows but I do envision a day where positive leverage and real investment fundamentals and conservative underwriting rule the day. No more 100% occupancy and 100% expense recapture with $0 attributable to reserves. Those days are over and I’m glad to see them behind us. Based on current interest rates for commercial property financing ranging from 7.00% – 7.75%, positive leverage is achieved at capitalization rates ranging from approximately 7.85% to 9.00% (depending on down payment percentage and amortization period). Any further increase in commercial interest rates (which will surely come) will push capitalization rates higher and we may just see 10%+ capitalization rates on quality assets. The sky is the limit for capitalization rates for B & C type assets as investors should flock to quality, especially at more attractive returns.
4 comments
john Reeder says:
March 6, 2009 at 5:04 pm (UTC -8)
I probably didn’t clarify my point well enough. You’re absolutely right that the relationship is inverse. So if the company trades at 20 times earnings, that would equal a ten cap.so the companies that are trading at the highest multiples of earnings are likely to be stable tenants as well. 15x earnings would be similar to a 7.3 cap. I will clarify my post.
chrisrod9 says:
March 7, 2009 at 5:48 am (UTC -8)
There should be some amount of correlation, I agree. Good post though.
john Reeder says:
March 6, 2009 at 5:07 pm (UTC -8)
Oops. I meant 20x earnings is a 5 cap. Sure wish I had double checked the comment prior to submitting
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