Risk Premiums Decline Along with Cap Rates

IRVINE, CA—Graphically, the upward trend in commercial real estate sales volume since 2009 resembles the crest of an enormous wave, while the trend for risk premiums looks more like the trough of that wave. Even the highest-risk asset class in '09—hotels, its premium at more than 7%—has seen its risk premium taper off to below 6%. That's one of the insights to be gleaned from Auction.com's Q3 Commercial Real Estate Market Monitor, issued Wednesday.

To plot the risk-premium curve, the Irvine, CA-based online CRE marketplace takes cap rates and factors out the 10-year US Treasury component, focusing on the expected yield corresponding to the risk of investment in each CRE sector. Auction.com notes that the risk premium for most asset classes has been flat for the past year, with the exception of apartments, for which the premium has declined 12 basis points from a year ago and 30 bps from the prior quarter. “This improvement in CRE risk premiums has enabled overall cap rates to continue to decline despite higher interest rates,” says Peter Muoio, EVP of Auction.com Research.

Now that the Federal Reserve has officially shut down its quantitative easing program, Muoio notes that “we could see a jump in interest rates, though other factors could keep interest rates low even as the Fed shifts gears. The potential for CRE risk premiums to edge lower and interest rates to resist the long-awaited increase may point to lower cap rates.”

In fact, cap rates have been trending down in all five major property types and are now below their 10-year average. In line with the falling risk premium for multifamily, cap rates in the sector are currently at a new 10-year low, averaging under 6%, the lowest level since at least the beginning of 2001.

“The continued strength of the apartment sector is directly related to the trends we've been seeing in residential real estate, namely the rise in household formations and the ongoing decrease in home ownership rates,” says Rick Sharga, EVP at Auction.com. “In many markets, demand is likely to continue to outpace supply, even with new inventory coming on line, as young adults decide to delay home purchases for a variety of reasons. Whether this is a cyclical or structural change in home buying patterns, it suggests that the apartment sector is going to continue to be strong for the foreseeable future.”

Although multifamily has surpassed all other asset classes in terms of both higher valuations and lower cap rates, it's hardly the only winner. Office, apartment and industrial sector prices are up 15%, 17.4% and 18.7%, respectively, year over year. Conversely, retail pricing increased by just 5% during the same time period, while hotel pricing has leveled off, a trend that Auction.com attributes in part to new supply coming on line.

With office and apartments combined representing nearly 60% of the dollar volume, CRE sales reached $97.5 billion in the third quarter of 2014, up 11.6% Y-O-Y. Auction.com cites investor confidence in US real estate amid global geopolitical risks and the tenuous economic situation in Europe.