Understanding the relevance of capital migration on asset pricing

[Chase McArthur]

I recently read a post regarding asset pricing that got me thinking about the dynamics of investment property valuation. Having read a multitude of posts on BP, it has become apparent that the majority of first time investors as well as a surprisingly significant number of smaller seasoned investors have a narrow view in regards to how a commercial property is priced these days. By no means is this an insult but rather an observed misconception.

When it comes to investment property valuation, often times it is the income approach that is utilized as a starting point in the development of an overall "guess-timation" on the market value of an asset. Obviously, this is the most important metric for valuation but not the deciding factor. The proper valuation ultimately relies on the market cap rates for the surrounding area, which of course is set by the recent comps. But how is the market cap rate determined? In my experience, the market cap rate is directly correlated to the migration of outside capital into the local markets. Take a look at the market cap rates for your AO, have you noticed that over the last few years the rates have compressed, in certain areas to a significant degree? This compression is being driven by demand which of course is illustrated by the amount of capital being invested into a particular market. This compression of cap rates is a direct effect of the migration of capital from outside investors. When non-local capital is introduced into a dynamic system, such as commercial real estate, the effects are felt mostly by local investors who are looking to enter into their market. This, of course, creates a high barrier to entry for those that are deciding to invest for the first time. However, for those who currently own, this increase in valuation is enabling those investors unprecedented opportunities to take advantage of either expanding their portfolios by tapping into the new equity of their existing investments, or selling at a significant profit and 1031 into a larger asset, hence capitalizing on economies of scale.

That being the case and all things being equal, how should the asset valuation be determined? This is where the understanding of capital migration and its dynamic effect on asset valuation is critical. Why is this important? Because as an investor it is your job to determine what asset price best suits your overall goals, which ultimately determines the strategy you will utilize to reach those goals. Often times less seasoned investors will begin with the asking price of a particular asset then run their numbers to determine whether or not the current asking price will support their investment goals; if it doesn't work they move on. Contrarily, a seasoned investor will run a reversion analysis to determine the actual price in which they can pay in order for the asset to perform according to their goals and base their bid on their results. This is why most all seasoned investors have a range of required returns rather than a set number in which all assets must perform. A seasoned investor also understands that unlike residential real estate, investment properties are intra-national. Capital has no borders. Therefore what may appear to be a ridiculous cap rate to you, may ultimately be a gold mine for a non-local investor. Local assets compete for outside capital along side local capital.This is why an astonishingly high number of transactions take place with non-local investors. Understanding this concept is critical in determining how your asset is priced, should you be the fortunate investor who is holding a property in a low cap rate market. If you are a local investor inside of that same market looking to buy, perhaps you should consider sending your capital across the border into other emerging markets. Broaden your horizon and don't let a property that is 2, 3, 400 miles away scare you from investing; if the numbers work, they work. Before you know it you may find yourself holding a property in a 3 cap market.

I would love to hear the thoughts of other investors and brokers...