Monday, February 23, 2009

When in Doubt, Use a "Ten Cap"

From Capital Trends Monthly January '09

For decades—before "cap-rate compression" became a catch phrase—yields on commercial property largely averaged between 9% and 10%. In 2009, it is quite possible if not probable that the market will "revert to the mean"—go back to the long term average for the asset class: basically, a ten cap. A 10% cap rate on current income has always been a broad rule of thumb in valuing property for investment, and not only because it simplifies calculations. The logic behind it is that a buyer is assured at least a double-digit return on investment.

As the story goes, Sam Zell's winning strategy in the early 1990s was to buy as much as he could at a 10% cap or better, making sure the price was also below replacement cost. He made billions this way, although correctly timing the exact bottom to buy and top to sell in each cycle also helped.

While this seems simple, it is important to note that the "ten cap" rule applies only to current or in-place income, giving little to no credit for vacant space, iffy tenants or additional development rights. An unleveraged double-digit return expectation is important to capture the attention of potential investors as well as cover any mezzanine debt costs.

ten cap

In 2002, over a third of all deals traded at a 10% cap rate or higher. By 2007, a 10% cap had become rare, accounting for less than 2% of all transactions.

Are we Going to a "Ten-Cap" Market?

The REIT sector is signaling that 10% cap rates are indeed a real possibility. The implied cap rate of the US REIT industry is now closing in on 10% according to studies published by JP Morgan Chase and Oppenheimer. The conventional wisdom is that public-market pricing leads the private market and there is some empirical evidence to back that up.

Looking at debt costs and doing the math also supports the theory that we could revert to the mean and thus be heading toward a 10% cap rate. Assume the following terms that ballpark the current market: a 7% mortgage rate; an 8% constant (don't forget, there is amortization again!); 60% loan-to-value; debt service coverage ratios of 1.75x to 2.0x. Doing the calculations (8% * 60% * 1.75), the cap rate would have to be at least 8.5% to 9.5%. However, even at that level, the return on equity is a modest 12%, especially compared to mezzanine debt costs that currently are closer to 15% or higher.

Yes, we may be heading to a Ten-Cap market in coming months, but that does not necessarily mean that the market is reverting to the mean for the long term. It can still be argued forcefully that the real estate capital markets have undergone a structural or secular shift toward permanently lower cap rates. After all, another truism is that "the pendulum always swings too far," meaning prices will over-correct to the downside. Thus, even though cap rates of 9% or 10% or more will become common in 2009, a more robust investment market will ultimately push them to a lower level than has historically prevailed but above the 5%-6% levels of the most recent few years.

Article courtesy of Real Capital Analytics Inc.

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