Capitalization or “cap” rates are a key metric in determining the potential rate of return of commercial real estate, as well as for ETFs and mutual funds that invest in the asset class. They equate broadly to yield, a key consideration for income-oriented real estate investors.
Cap rates are determined by dividing a property’s net income by its market value. High cap rates indicate a good return on investment, but of course they can also signal more risk. Cap rates tend to decline – become compressed, as they say in the industry – the longer the real estate cycle goes on, as prices for properties are bid up and returns go down.
To make things more complicated, you can’t really calculate a single cap rate covering all of commercial real estate. Cap rates vary by property type, as do returns. So cap rates for office properties can be low while those for industrial or multi-family can be high, and vice versa. We are now well into a period of recovering real estate values, so what are cap rates saying now about the asset class?
The short answer is it depends. For example, cap rates for retail were up 10 basis points in the second quarter, a significant jump, according to a recent story in National Real Estate Investor.1 Some types of retail properties are doing better than others, in particular those that avoid direct competition with Amazon, and standalone businesses like medical clinics and quick food restaurants have also been doing well. Malls, on the other hand, have been under pressure.
While areas of retail have suffered, industrial has been a major beneficiary of the move to online shopping, with distribution facilities being built all around the country to meet growing logistical demand. This has led to a slight decline in cap rates nationally, from 5.6% in mid-2017 to a more recent 5.4%, according to Cushman & Wakefield.2
Multi-family, too, has seen significant growth in recent years, bringing new supply to the market. A recent report from Freddie Mac predicts slowing but continued growth and notes that the “demographic drivers for multi-family demand remain strong.”3 It predicts that rising interest rates will ultimately lead to an increase in cap rates. In office, asking rents have been moving up as new supply comes online, with cap rates averaging approximately 6.5% in the first quarter of 2018.4
The upturn in real estate that began nearly ten years ago has continued across most property types and is in line with the growth in the U.S. economy. Regional markets show some divergence, and some property types have done better than others, but in general the returns have been attractive, with small cap REITs outperforming their large cap counterparts. The Bloomberg REIT Small Cap Index has an annualized total return of 15.99% vs. 6.59% for the Bloomberg REIT Large Cap Index for the 10 years ending June 30, 2018.5
While there are legitimate concerns about where we are in the real estate cycle, with supply starting to exceed demand in some markets and property types, the overall outlook remains favorable. Yields remain attractive relative to the overall interest rate environment. As of May of this year, the FTSE Nareit All Equity REIT Index had a yield of 4.11% compared to 1.95% for the S&P 500. With the Fed now in the process of tightening interest rates, Real Estate Investment Trusts (REITs) offer another possible benefit: providing potential risk mitigation in a rising interest rate environment when rates are rising as a result of a strengthening economic environment as they’re doing now. Research from Nareit, the industry trade association, indicates that REITs had positive returns in 87% of rising rate periods going back to 1992.6
Taken as a whole, commercial real estate appears to be pretty healthy, with strong performers balancing out those that are less robust – yet another reason for participating in this market through the kind of diversified portfolio found in a well-constructed REIT-focused fund.
To learn more, visit IndexIQ Chaikin ETFs here.
1. Liz Wolf, “The Net Lease Retail Market Is Showing a Shift, with Higher Cap Rates and More Listings,” July 2018.
2. Patricia Kirk, “Are Industrial Values Getting Too High?” April 2018.
3. Freddie Mac, “Multifamily 2018 Outlook,” January 2018.
4. Lanie Beck, “2018 Office Sales Volume & Cap Rates”, January 2018.
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