CAP Rates on the Rise?

Chase Mayhugh, SIOR, CCIM

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In the commercial real estate market, cap rates across all sectors, whether credit or non-credit, are beginning to rise. Over the past decade, cap rates steadily decreased to their lowest levels in decades. Several factors contributed to this trend, including increased money supply, historically low-interest rates, investor migration to business-friendly states, and the lack of attractive alternatives like treasuries, which offered minimal returns and provided no hedge against inflation. These circumstances led investors to favor real estate as a comparatively robust investment. While I still hold the belief that real estate remains the best investment vehicle, the timing and underwriting of real estate investments, as with any investment, are critical. So, where are we headed from here? In the short term, and given the Federal Reserve's current stance that inflation is still higher than they prefer, they are likely to continue increasing interest rates. This will keep treasury yields elevated for an extended period, requiring commercial real estate investments to provide returns that match or surpass what treasuries offer. Consequently, cap rates will need to increase significantly. For investors who enjoy leveraging their investments to boost cash-on-cash returns, this will mean putting more money down, possibly 40% to 50% or more, and waiting for interest rates to decrease. In addition and most importantly should investors want to leverage they will need significantly more down in most cases to meet lender's DSCR requirements.

Currently, there exists a notable disconnect between what investors are willing to pay and the expectations of sellers. The days of accepting 4% to 5% cap rates are, for the most part, over. Investors are now seeking cap rates north of 6.5%+ to secure more favorable returns on their commercial real estate investments. The market is adjusting to this new reality, and it's essential for both buyers and sellers to adapt their expectations accordingly.