Future Shock When Capitalization Rates Return To Historic Norms

At a recent luncheon with several regional bank appraisal review officers, the subject of Capitalization Rates was broached. The question was; “Why 7% to 9% rates when not too many years ago the norm seemed to be 10% to 12%?”

Short answer;
Federal Reserve’s intervention or buying of funds (buying of T Bonds and T Bills to keep rates low).

Long answer;
The market for real estate is a “long term investment market” that sometimes is influenced by short term occurrences.

The 2007/ 2008 Sub-Prime Debacle is one event that influenced most major urban commercial real estate capitalization rates and markets.

The axiom in play is / was the “Substitution Principle”.
“What are the alternative investment comparative returns available to the level of investor that is attracted to real estate?”

If a 10 year US Fed. T Bond is in the 3.75% yield range and alternative investments with more risk are available at 5% – 6% yields, [and under], then;
Quality income producing real estate, (well leased and located urban shopping centers, industrial buildings and office building, etc.), may look attractive at 7% – 9%, [even if it is not liquid like stocks or bonds].
Example 1:
A shopping center that has a hypothetical $100,000 per year NOI
Formula for Direct Capitalization =NOI / Return or Yield Required

A sale to an investor that requires a 7% return on their investment could sell for 1,428,571.

A sale to an investor that requires a 10% return on their investment could sell for $1,000.000.

A sale to an investor that requires a 12% return on their investment could sell for $833,000.
Example 2:
A real life example;
A bank client asked us to re-appraise several retail strip centers. We were to use only the direct income capitalization approach, presumably to save on costs and they were familiar with the properties (5 year loan history).

The first time we appraised the properties the market derived appropriate direct capitalization rate was 9.5%.

Five (5) years later the market determined appropriate capitalization rate (CAP rate) was 11.5%.

The net operating income (NOI) had increased about 10% and vacancy was down from 12% to around 10%.

The value when utilizing just the direct capitalization income approach “As Is” declined.

You could imagine the ear full the loan officer got from the owner.

A possible explanation to “other parties”;
A owner or loan officer might choose to go back to the lower capitalization rate appraisal and capitalize the then (previous) income (NOI = net operating income) at the current (higher in this case) CAP rate and show the client / borrower / loan committee that the property is performing, but the required return by investors has increased therefore driving down the market value of the income stream at this time. [“Appraisal is a Snap Shot “As Is” because of FDIC and other restrains”.]

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