August 4, 2018: Cap Rates & Sales Volumes

One of the troubles I predicted would characterize the 2018 CRE markets is the bid/ask gap widening between sellers and buyers. Sellers are finding that prices aren't rising as quickly as they have over the last five to ten years and thus are finding it difficult to sell at their previously underwritten exit prices. Furthermore, because of interest rates still being historically low, sellers can refinance in lieu of selling and thus eliminate reinvestment risk late in the cycle.

These factors have put downward pressure on investment sales volumes which in turn has caused cap rates to modestly rise especially in office and retail. Multifamily and industrial still have economic and demographic tailwinds driving growth, keeping investors optimistic. "But there also is a lingering sense of conservatism in the market. Transaction volume remains less-than-stellar even with plenty of capital in the marketplace. This is because sellers, thanks to the booming debt markets, have the option to refinance their properties and wait for better pricing, Heller says. “The problem is incongruency between seller expectation and buyer tolerance,” he adds." (Diduch).

Buyers are underwriting deals (hopefully) more conservatively, especially due to rising rates. Today, we are underwriting five year terminal cap rates at at least 100 basis points higher than market, sometimes 150. This causes us to 1) lower our return expectations and 2) be extremely selective with our deal sourcing. "And in a later stage of the real estate cycle, buying selectively is the way to go for many investors, Heller says. “Most funds still have plenty of time, so they’re not running out of investment runway,” he notes. Questions also remain about the pace of interest rate increases, following nearly 10 years of historically low rates. Investors now have to anticipate a higher exit cap rate once their hold period is up; some may not make as much money as they expect, Weiser says. “I think people are less comfortable with that,” he says." (Diduch). Investors who are extrapolating recent, past results into the future may get themselves into trouble if rents decrease, vacancies increase, or cap rates rise (or all three).