Latest posts by Randolph Taylor (see all)
- Multifamily Chicago Report - April 23, 2019
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- Illinois Rent Control Webcast Tomorrow - March 19, 2019
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Capitalization (cap) rates are the most commonly used metric by which real estate investments are measured. Which begs the question – what is a good cap rate for an investment property? As with any complex topic, the answer is that it depends.
It’s important to remember that a property’s cap rate is simply its annual net operating income (NOI) divided by purchase price, and represents the unleveraged annual return on the asset. Because one of the driving factors is income, often times cap rates are “projected” based on an estimate of future income.
Different cap rates between properties should in theory represent different levels of risk. A lower cap rate should correspond to a lower level of risk, while a higher cap rate should imply more risk in the deal. As an investor, the challenge is to determine the appropriate risk-adjusted return, or in other words, the right cap rate given the riskiness of the deal.
When analyzing a potential investment property to determine the right cap rate, there are several core factors one can look at, including location, asset type, and the prevailing interest rate environment. Let’s examine each to see how they affect cap rates.
You are likely familiar with the old adage “in real estate, location is everything”. This is because the value of any real estate property is driven by demand, and that demand is largely affected by the location. Location can refer to both the Metropolitan Statistical Area (MSA) a property is in (e.g. Seattle vs. New York), and where within that MSA (e.g. urban vs. suburban) it’s located.
The United States consists of a vast amount of relatively undeveloped rural land, as well as 381 Metropolitan Statistical Areas (MSAs). MSA is a formal term used by the US Office of Management and Budget (OMB) to describe a geographical region with a relatively high population density at its core and close economic ties throughout the area. It is often used by real estate investors interchangeably with terms like “metro area” or “market”. Each market has its own set of underlying economic fundamentals – to take a few examples:
These fundamentals have a huge impact on risk and therefore cap rates.
As you can see, investors were willing to accept an average 5% lower annual return in Los Angeles vs. the same type of asset in Memphis. Why? Because they perceive Los Angeles to be a less risky market based on its fundamentals. LA has a larger, wealthier, and better-educated population, which drives a more dynamic local economy and should make demand for office space stronger over the long-term.
As anyone who lives in or near a major US city knows, home prices are generally higher the closer you get to downtown. The same is true of commercial real estate, where prices are higher, and cap rates therefore lower, in the central business district (CBD). Investors are willing to pay more for CBD assets because, as you might have guessed, they perceive the risk to be lower than in the suburbs.
This goes back to the fundamentals of real estate being a scarce asset with intrinsic value. There is only so much land available in the CBD, and there is a natural demand for it because it’s close to other businesses and key infrastructure like mass transit, ports, highways, etc.
Cap rates also vary significantly within a market, across different asset types.
In commercial real estate, not all asset types are created equal when it comes to perceived risk. Multifamily assets consistently have among the lowest cap rates within a market, because they are considered to provide lower risk relative to other asset types. This is true for two main reasons:
Perhaps the most complex and least intuitive part of understanding cap rates is their relationship with interest rates. Often in real estate cap rates may shift without any change to the actual property or surrounding area but only as a result of a change in interest rates. That is because investing in real estate property is largely driven by the amount of debt that can be borrowed to purchase a property and the resulting spread between the interest rate and the cap rate. The larger the spread, the better the potential return. This makes sense if you think of the interest rate as the cost of money, and the cap rate as the value of that same money when invested into the property.
It’s important to note that artificially adjusted interest rates (such as those set by the Federal Reserve) can artificially impact cap rates. In other words, with no underlying changes to the real estate asset or inherent risk to the deal, a property’s cap rate can fluctuate by 0.5% - 1.0% due to the change in interest rate. While that may not seem like a lot, it can have a heavy impact on the property’s value.
For example, imagine a stabilized apartment building which was purchased for $10 million and generates $750,000 in NOI each year (a 7.5% cap rate). The property was financed with $6 million of debt at a 5.0% interest rate, which costs roughly $386,000 per year. This would make the levered yield 9.1%.
Now, imagine that a few years have passed. Nothing has changed about the deal, but the interest rate on a new loan with the exact same terms as the original has increased from 5.0% to 6.0%. This would increase the cost of the debt service to roughly $430,000 per year. In order to achieve the same levered yield of 9.1%, a buyer would only be willing to pay $9,516,000 for same property. The property value has decreased by nearly $500,000, and the cap rate has increased from 7.50% to 7.88%, even though nothing changed about the property itself.
The implication for the cap rate increase is that the risk of the investment also increased, but in reality, this doesn’t seem like the case. After all, you’re still dealing with the same asset in the same market – all that changed was the interest rate.
However, if we go back to the fundamentals of finance, you’ll recall that the return on any investment can be broken into two parts: the risk-free rate of return, which is usually defined as the rate of return on the US Treasury note, and the risk premium, which is the extra money you’re getting paid to compensate you for the additional risk you’re taking on. When the risk-free rate of return increases (when the Fed hikes interest rates), then you’re getting a lower risk premium on the same investment. In other words, you would be overpaying if you bought that property at the same original price, so the property value drops (and cap rate increases).
This principle holds true for asset values across the economy. If the risk-free rate of return increases, then the amount of money you would be willing to pay for an asset that generates an additional risk premium would decrease accordingly.
The cap rate is a comparative metric which is most valuable when it’s used to compare against very similar subject properties – that is, properties with a similar location, of the same asset type, and which are valued at the same point in time. A “good” cap rate is completely dependent upon this context. The smartest real estate investors are the ones who are willing to ask the hard questions and ensure they’re being adequately compensated for the risk they’re taking on.
Source: Fundrise, Chris Brauckmuller on May 13, 2016
This week's off-market purchase by Healthcare Realty Trust of a 103,500-square-foot medical office building on the campus of Inova Loudoun Hospital in Leesburg, VA, is the latest example of the fever-pitch competition among buyers for a limited supply of institutional-grade MOB properties available for sale.
"This is as core as core gets, and this kind of high-quality medical office asset seldom trade in the Washington, D.C. market because most of the dominant health systems in the region such Johns Hopkins own all the assets that they occupy," noted Avison Young principal Jim Kornick, who led the team representing a joint-venture between developer Foulger-Pratt and a global real estate investment management firm, which sold the asset for an undisclosed price. "There are just not a lot of trades."
While overall medical office building prices peaked a year ago, pricing has only become more competitive for core MOB assets as investors of every type have retreated from secondary and tertiary markets back to reliable core assets in primary markets, Kornick said.
With strong demand and positive sentiment attracting new types of investors and adding to the competition among buyers, MOB deal velocity accelerated 17% in the trailing 12-month period ending June 30, according to Marcus & Millichap. Average pricing per square foot of medical office space has also advanced 17% to $230 PSF since the end of 2014, according to Marcus & Millichap's analysis using CoStar data.
"We had tremendous 20% growth from 2014 to 2015, and clearly, it's continuing on into 2016, albeit maybe not at the same high levels," said Marcus & Millichap's John Smelter, a veteran of three decades in the healthcare real estate. "The demand is absolutely there."
Smelter noted that the MOB vacancy rate dropped 80 basis points to 8.6% in the second quarter from a year ago, the lowest level in eight years.
Despite recent news and accompanying noise on the presidential campaign trail about potential premium increases, next year for Affordable Care Act plans, analysts cite rising patient counts from expanded health coverage under Obamacare, combined with the demographically aging U.S. population, as major demand drivers for the medical office building sector.
Also, as hospitals and health-care systems continue to buy-out private practices and move outpatient services off of main hospital campuses, major health-care providers now control a large share of MOB leasing activity, resulting in heightened demand for newer modern buildings with flexible floor plans. This has resulted in a rise in both new projects and deliveries of new space in 2016, M&M said.
In particular, institutional-grade property deals have seen a substantial uptick in transaction velocity in recent quarters. Sales of such properties have only been limited by a lack of available properties on the market, M&M added.
Off-campus properties with strong tenants with long-term leases are selling for a premium. Other types of off-campus MOBs, including those located in secondary or tertiary markets or properties in need of repositioning, can trade with first-year yields up to 200 basis points higher.
But the single biggest factor behind the booming MOB investment market Marcus & Millichap reports is that several REITs and major investment funds that typically focus on senior housing are currently diversifying their portfolios and reallocating large sums for acquiring medical office buildings and even hospital properties.
REITs have announced at least six deals to buy more than two dozen hospitals in the first three-quarters of 2016. In the largest such deal, Medical Properties Trust, Inc. (NYSE: MPW) last month agreed to acquire the real estate interests of nine acute-care hospitals across Massachusetts operated by Steward Health Care System LLC for $1.25 billion.
Other MOB investors who previously targeted stabilized assets in core markets are eschewing the lower-risk but higher priced options and scooping up value-add properties or even participating in the development and equity placement, Marcus & Millichap said.
One of the newer investors in MOBs is Bethesda, MD-based Global Medical REIT Inc. (NYSE: GMRE), which this week closed on the purchase of nine medical office buildings in three separate portfolio transactions in South Dakota, northern Ohio and East Orange, NJ, with three more buildings scheduled to close in December, for an aggregate $30.9 million.
Source: CoStar Randyl Drummer October 12, 2016
Office Investors Increasingly Active Across More Secondary Markets Even as Core Gateways Maintain Their Luster.
Last year saw the return of a thriving office investment market, so much so in fact, that several local markets saw significant chunks of their overall stock of buildings change hands in 2013.
Analyzing such office inventory turnover can provide a good barometer of where office investment dollars are flowing, and also reveal markets that offer opportunities for further investment.
"While overall CRE investment volume rose 14% in 2013 from 2012 levels, office sector activity increased 17% to over $104 billion, the highest annual volume recorded for the four major property types,” said Nancy Muscatello, senior real estate economist with CoStar Group.
"Although last year’s haul was still shy of the peak office investment levels we saw in 2007, it does demonstrate the return of strong investor interest in office property, although that wasn’t necessarily the case everywhere.”
Looking at office inventory turnover trends across the top 54 U.S. office markets, five Southern and Western markets saw more 10% or more of their total office market inventory change hands last year: Austin, Dallas/Fort Worth, Atlanta, Houston and Denver. Austin was especially popular with office investors as 13% of its office space was acquired by new owners in 2013.
Six office markets saw just 3% or less of their stock change hands: Long Island, Sacramento, Baltimore, Pittsburgh, Honolulu and Richmond, which posted the lowest turnover of 2%.
The surge in transaction volume in many of these markets was predictable, Muscatello said.
"Houston is a shiny object that investors cannot seem to get enough of, offering a bulletproof demand story and fairly decent yields," as a result trading volume has soared in some key submarkets, she said.
“Austin has also been on the radar of investors for quite some time. The metro had a huge inventory turnover in 2013 (13.1% of inventory,) although a sizable portion of that (40%) was due to portfolio sales," Muscatello noted. The biggest portfolio to trade hands last year in Austin was the sale of the Thomas Properties Group portfolio of five trophy CBD towers as part of the firm’s acquisition by Parkway Properties.
Chris Hightower, an investment broker with Marcus & Millichap in Austin, said the ownership changes demonstrate the evolution of the Austin market. Historically, big institutional buyers have eschewed the ‘Live Music Capital of the World’ due to its relatively small size compared to major markets.
“However Austin has become real estate darling due to the hard charging Austin economy,” Hightower said.
Meanwhile, some of the nation’s core coastal markets saw relatively lower inventory turnover, including Washington, DC, San Francisco and New York, where just 5% of inventory traded hands. As a way of comparison, the average across the top 54 U.S. office markets was 6.33% turnover.
"Of course, that’s due in part to the size of those markets,” Muscatello noted. “Not only were they at the forefront of investment activity early in the recovery, but markets like New York and Washington DC have office inventories that are much larger than the average market. Investment volume in New York for example, still accounted for 23% of all office sales in 2013, even though New York’s share of the office inventory is only 10%. San Francisco also pulled in an outsized share of sales volume in 2013.”
Andrea Cross, national office research manager for Colliers International, also noted the turnover trend in the gateway markets.
"New York, San Francisco and Boston experienced the strongest demand from investors coming out of the recession, so many office assets in those markets have already traded. Lower inventory turnover in 2013 is attributable to a shortage of available assets and strong price increases in recent years rather than a lack of interest in those markets,” Cross said.
It's not so much that investor interest has waned in those markets, but rather it has expanded to include others.
“Office turnover in markets outside of the core gateway markets has picked up with broader economic growth and higher investor confidence in the office market’s recovery,” Cross said. “We are seeing higher turnover in many markets that were out of favor earlier in the recovery.”
Markets such as Nashville, Jacksonville, New Orleans and Las Vegas all saw 8% turnover in office inventory last year, according to CoStar data.
“Office sales volume is certainly on the rise in secondary markets as the recovery spreads to more markets and investors move out on the risk spectrum in search of higher yields,” Muscatello said.
Source: CoStar Mark Heschmeyer February 26, 2014