The Revaluation of Private CRE

The Federal Reserve has increased the federal funds rate several times in 2022 from zero percent in March of this year. This has been the fastest rise in the funds’ rate ever and has begun to impact the CRE market. The public REIT stocks have already corrected with the FTSE-NAREIT All Equity Index down 27.93% through September 2022. Higher interest rates and a slower economy have revalued public REIT prices but not private commercial real estate values. Rising risk-free rates increase the weighted average cost of capital and when a company’s free cash flow is discounted at this higher cost of capital, the value of the company and its stock declines. The private CRE market is at a standstill and there are few transactions due to the large and widening bid-ask spread of property values. Therefore, private CRE values have not been corrected in line with the public REITs, and it may take another nine months to a year for these values to reprice lower.

Let’s say the 10-Year T-Bond rate is 4.0% as it was earlier this fall. With this higher risk-free rate, an average cap rate can be calculated from the cap rate formula, which is the risk-free rate based on the 10-Year Treasury of 4.0% plus a risk premium of 6.0% less the growth in rents of 3.0% or a cap rate of 7.0%. This is a general cap rate and needs to be further adjusted for the property type and location. However, a minimum cap rate for even the booming industrial market should be 5.0%-7.0%, and not the 3.0% to 5.0% currently in the market and for apartments cap rates should rise to 5.50% to 7.50%, versus 4.0% to 6.0% currently in the market.