How do capitalization rates impact commercial real estate values?

Real Estate

How do capitalization rates impact commercial real estate values?

Commercial property values recently were hitting peaks with investors rushing to invest in high-quality commercial real estate as yields on other assets like Treasurys continued to languish. Now the tides have turned with high-quality commercial property worth substantially less.

What happened?

The coronavirus arrival brought with it the closure of many commercial places, upending any sense of normalcy in the commercial real estate market. Assets that were deemed safe Class A properties became highly risky assets. Take, for example, a retail store steps away from a major stadium. This was very desirable prime real estate until the pandemic hit in March. Now how valuable is this property with zero sporting events, concerts or other events?

Three property types now are considered risky:

1. Restaurants: This always was a risky property type due to constant change in the industry, but the virus has upended all assumptions as dine-in services were temporarily banned in most locations – and currently cannot exceed 50% capacity. I’ve seen numbers as high as 30% likely will fail. If you had an A restaurant in an A location within a city, the property was considered relatively safe; now the entire industry is under siege financially and many will perish.

2. Retail:The recent retail numbers show a 17% decline in purchases and almost an 80% decline in clothing purchases. This will be a nail in the coffin not only for many large retailers like Neiman Marcus but also for smaller retailers. Think of the high-end malls with all the clothing retailers; how do they survive such a dramatic drop in sales?

3. Office: The office landscape has changed. Companies like Twitter and Google are telling employees they can work from home, some indefinitely. Why would large companies need so much space going forward? They will not. The space they will desire is smaller and in less dense locations to minimize the risk of virus transmission.

On the flip side, some properties have excelled:

1. Grocery-anchored centers: Grocery stores that were languishing are now hot again as consumers are forced to eat at home more than they did prepandemic, which has increased margins and brought back life to a sometimes tired real estate sector.

2. Light-industrial: Industrial and light-industrial properties were in demand before the virus hit, and now the space needed to store inventory and sort items for distribution is enormous. This sector will be the biggest winner.

How does this impact commercial capitalization rates?

To value commercial real estate you can look at what comparable properties are selling for and calculate the net operating income to determine the value. The income approach is critical to the valuation of a property. The basic calculation of NOI is revenues minus expenses, excluding mortgage/interest payments. The NOI then is divided by the capitalization rate to determine the value. For a basic example, let’s assume a property’s NOI was $100,000 per year and that the property was a high-quality property so the cap rate was 5%, so the value would be $2 million.

What is cap rate?

The capitalization rate is used to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income, which the property is expected to generate, and is calculated by dividing NOI by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on his investment in the real estate market. In essence, the cap rate is a measure of the “riskiness” of a property. A higher cap rate would deem a property more risky, and a lower cap rate would mean the property is low risk.

How will commercial values be impacted?

There are two primary variables impacting value – the net operating income from the property and the expected return on the property (cap rate).

The income on many properties is declining substantially due to the virus. For example, the lease rates on office space are plummeting due to lack of demand; furthermore, existing office users are negotiating lower rent rates to continue their leases. On top of this, vacancy rates are ticking up as companies close or substantially scale back.

Meanwhile, cap rates are surging as properties that once were deemed “safe” now are very risky. For example, a restaurant in a great location might have traded on a 4 cap, but now that property might trade on a 7 or 8 cap due to the uncertainty in the industry.

In another example, let’s assume a restaurant pays $100,000 a year in rent and it is a triple-net lease, when the property was bought, a 4 cap was used – with the changes, now the cap rate has increased to 7% or 8%. The original value was $2.5 million, but now the value with a 7 cap is only $1.4 million. If the same restaurant renegotiates the lease by 20% due to the new social distancing requirements and the loss in income and the NOI decreases to $80,000, assuming the increase to a 7 cap, the value now is $1.1 million.

Many commercial properties are in for a tough ride in 2020 and beyond as net income is reduced and cap rates are increased. This is just the beginning as there is considerable uncertainty as to how deep the income losses will be when leases come up for renewal and how substantial the cap rate increases will be due to the riskiness of the asset.