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One of the key issues on everyone’s mind in CRE is “Where are cap rates headed when the pandemic ends?” Cap rates have been compressed to-historic lows since the end of the Great Recession in 2012 and this has been primarily due to the drop-in Treasury rates, courtesy of the Federal Reserve. The Covid pandemic created a very uneven CRE market in 2020 with overall transaction volume down about 50% and valuations stressed. Retail and hotels suffered the biggest hits to valuation while industrial and data centers outperformed. Office and apartments located in high cost and high tax urban cities were pummeled, while suburban and low cost and low tax state properties did fairly well.

The cap rate on a property can be calculated in two ways. The first is the actual or dollar cap rate determined by dividing the net operating income of a property by the cost or value and the second, by a cap rate formula. The cap rate formula is the risk-free rate plus a risk premium less the growth rate in rents. The risk-free rate used in the cap rate formula is typically the 10-Year Treasury Note which is currently 1.60% and the risk premium has historically been between 3.0% to 10.0% and we estimate that it is about 8% today. If the average growth rate in rents is 3.0%, then the cap rate formula produces an average cap rate of 6.60% (1.60% + 8.0% – 3.0% = 6.60%). This is an average cap rate and needs to be adjusted further up or down depending on the location and type of property. The discount rate used to discount the yearly NOI are the first two figures in the cap rate formula, the risk free rate plus the risk premium and today, it’s is typically between 7.5% and 9.5%.

 

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