Multifamily, Office Cap Rates Have More Room to Expand

Cap rates are one of the daily metric companions in commercial real estate. To the pleasure of buyers and distress of sellers, they’ve moved steadily higher over the last couple of years as property values drop and forward rate growth is stifled.

That may be coming to an end, suggests CBRE. The firm used multiple cap rate estimation techniques for comparison. While cap rates in general seemed to be heading toward an apex, office and multifamily both looked as though there were more room for expansion.

The four estimation techniques that CBRE used were as follows:

Add the average historical spread of cap rates over the 10-year Treasury yield to the current yield, extending a typical spread from the past to current conditions. CBRE looked at the average spread from 2010 to 2020. That was 230 basis points for multifamily, 280 for office, 320 for retail, and 340 for industrial.

They used a fair value cap rate and then the Gordon Growth Model, which expects constant-rate annual NOI growth. CBRE used “the discount rate (risk-free rate (10-year treasury) + risk-premium) minus the expected income growth rate.”

CBRE generated a debt service coverage ratio implied cap rate, “multiplying the all-in cost of debt (5-year swap rate + credit spread + amortization factor) by the LTV by the DSCR.

The fourth method was a REIT-implied cap rate as reported by NAREIT.

“The cap rates suggest that the office sector has the furthest cap rate expansion to reach appropriate pricing for trading volume to recover,” they wrote. At 7.0%, the spread-implied cap rate was about 60 basis points higher than their estimate that “is likely underestimated” because the previous average doesn’t include the post-pandemic changes in office use. The office estimate differs by about 130 basis points from the REIT-implied cap rate of 7.7%.

Their multifamily cap rate estimate was 5.3% — below the spread and REIT-implied rates were 6.5% and 6.4% respectively and above the fair value rate and just below the DSCR-implied one.

Those differences are likely why CBRE thought that office and multifamily could have room for even higher cap rates than they do now. It suggests that the idea of distress and market weakness could be strongly connected to general cap rates.

“Retail and industrial seem to have more appropriate pricing now,” CBRE said. “Using multiple perspectives to analyze cap rates can be helpful during these volatile times.”

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