3 Reasons Why Cap Rates Are Moving Up

By: Chris Hotze

August 6, 2020

The pandemic, and economic downturn is going to impact commercial real estate pricing. Here are three reasons why.

Cap rates in commercial real estate have been at historically low levels over the past few years. As borrowing rates plummeted over the last few years, so did the cap rates. When Cap rates plummet, the prices that a buyer will pay for an asset increases and the amount of money a lender will lend against a property will increase. The opposite happens when Cap rates increase, the amount a lender will loan on a property decreases.

REASON #1: EFFECTIVE INTEREST RATES ARE ON THE RISE

There is a direct correlation between effective lending rates and Cap Rates. Even though interest rates continue to be at historical lows, many lenders are increasing their spread by increasing the risk premium on a loan. Many sub-markets, like hospitality, retail and even office are seeing lenders require more of a "spread" on their loans. In reality, lenders are much more cautious with the pandemic and the impact that it has had on unemployment in general.

REASON #2: INVESTORS MOVING TO THE SIDELINES

Investors are motivated by two things: fear and greed. When a cycle turns in such a dramatic fashion, as it has with the 2020 Pandemic, investors have turned to a fearful posture. For the most part, new developments have slowed.

When investors pull out of the market, demand for the asset decreases and the value of the real estate goes lower. When competition leaves the market, Cap Rates increase. In simple terms, when there are not as many people pursuing an asset, the ultimate buyer is going to pay less.

REASON #3: DISTRESSED PROPERTIES

Everyone knows that social distancing, working remotely and closure of business impacts tenants. Developers and owners who are caught with the wrong asset class or in the wrong place at the wrong time of the cycle turn will be impacted by vacancies.

Even the most storied real estate has been impacted. Ryman Properties, the owner of the Grand Ole Opry and related hotels just reported a major decline in revenue year over year. Revenue for the quarter totaled $14.68 million — a 96.4% decrease compared to $407.7 million in last year's quarter. These numbers are so big, that it is almost hard to comprehend. Certainly, this example is not unique to just the very largest owners. Small businesses are being hammered.

CONCLUSION

Commercial real estate is an inefficient market. When a shock to the economic system happens so rapidly, Buyers and Owners typically have a broad divergence of what they believe the prices of their assets should be. Owners want the Cap Rates to remain where they were, pre-pandemic, of course. Investors, on the other hand, see more risk, and are likely to wait around for more clarity. To get the interest of investors, back into the game, Cap Rates are likely to rise. In the meantime, we are all in a waiting game recognizing that this is a period of price discovery.

Chris Hotze is the CEO of Crescere Capital in Houston, Texas. Chris is the author of Mailbox Money Mindset.