What a New Level of Cap Rates means to Future Investments

Past Cap Rate Trends

Over the past 36 months, investor pressure to buy attractive income-producing properties has caused the up bidding of prices without a corresponding increase in property productivity. Consequently, the spread between mortgage interest rates and cap rates has been squeezed down substantially from where they were prior to that period.

In major metropolitan areas on the West Coast, the demand for attractive apartment complexes has caused the spread to be very, very small in some instances. It’s a new level of cap rates and this cap rate compression will probably remain as long as there is no threat of economic recession and the fear of interest rate increases lies dormant.

Future Cap Rate Trends

What happens if interest rates start to bump upward or issues influencing total employment start to diminish so that tenants are unable to afford higher rents? A rather dramatic change in net operating income. This will spook the investor feeding frenzy/appetite for buying to cause the spread to decompress and the cap rate to rise.

So do you set on the sideline and try to wait out the period where this could happen? NO! Just don’t use heavy leverage. This is of greatest concern to those who use heavy leverage and are forced into a position where they either have to sell or refinance because of a balloon payment. Most investors only experience a negative consequence when they must sell because of the 4 D’s (death, divorce, debt, or no longer earning the desired rate of return).

Takeaway: A new level of cap rates is currently being established on trophy properties. We are seeing unheard-of cap rates and sales prices that have never been reached in the commercial real estate market.

A New Record Cap Rate Sale

A recent article in Bisnow.com indicated that Suburban Walgreens just sold at a record cap rate. According to the article written by Karen Jordan, of Bisnow, LA, a recent sale of a single Walgreens store in Thousand Oaks sold at a record price of $15.7m that set a new cap rate at a flat 4%.

According to the Listing Broker, Colliers SVP Eric Carlton, the deal was a quick 21-day escrow closing and was all cash. This is a rare find for a buyer like that for such a large deal.

How to Take Advantage of the New Level of Cap Rates

With cap rate compression (sales prices rising), we are seeing a frenzied market. How do you protect yourself?

1. Find a good, experienced and knowledgeable Real Estate Broker who understands markets, cap rates, and the nuances of commercial real estate.
2. Next you shop for a lender. Any lender that I know is willing to listen to your needs and give you a general “Letter of Interest” which ballparks the rates and terms that they would be able to offer you. This is critical to have in place so once you find the right asset you are ready to move quickly.

Most of the attractive NNN retail opportunities (Walgreens, AT&T, Verizon, Dollar General, etc.) will require that you move quickly through your due diligence time period. Some sellers require that you complete it within a 21-day time period. You need your lender/money source on board prior to having your offer accepted so the minute you receive an accepted offer your Real Estate Broker, your lender, and you can launch into the due diligence process. You can take advantage of this new level of cap rates if you work smart. Call me today if you need more tips or advice on how to protect yourself.