Buying property at low cap rates is one of the worst strategies in CRE investment and finance. I have published three books on CRE investment and two of them are titled, "The 50 Commandments of Commercial Real Estate Investment" editions I & II.
The first key detail is that "acquiring commercial real estate at low capitalization rates significantly increases the odds that the equity investors will eventually lose their capital." This is exactly what is occurring today in the 28th month of the Fed's higher interest rate crusade with the federal funds rate at an elevated 5.25%, up from 0% in March 2022. Property deals in major markets that looked solid back in 2019 and trading at these sub-5% cap rates have now become an albatross and misery for the owners and lenders.
Many investors did not read the 50 Commandments treatise during the last several years and went ahead and bought CRE assets at thin cap rates from 3.25% to 5.0%. These investors were hoping that interest rates would stay low, cap rates would follow, and they would be able to dump, I mean, sell the property to the next chump, I mean, buyer at the same compressed cap rate. The low cap rate regime became a game of musical lifeboats on the Titanic and the big question was, who would get stuck without a lifeboat as the mighty ship sank? As some of us have witnessed over the last few years, many investors from the largest private equity firms to local real estate developers have succumbed to this cap rate misery.
If a CRE property was purchased in 2019 for $50 million at a 4% cap rate with 60% debt at an interest-only rate of 3.5%, held for five years with 2.5% net operating income (NOI) inflation and sold at the end of year five at a 6% cap rate, the equity investors would see a negative internal rate of return of 10% and lose $7 million of the $20 million in equity. If the NOI declined during those five years like many urban office buildings, the negative IRR and loss of equity would be much greater. Below is a cap rate and valuation table which shows the large swings in value when cap rates go up and down.
While buying at low cap rates and selling into a market with much higher cap rates is dreadful, the CRE market today is poised to offer the opposite scenario. Cap rates on average have risen from the sub-5% area to 6%-7%+ depending on the property type and location and this is an opportune time to buy CRE assets. The dirty little secret in Washington is that the Federal Reserve will at some point have to begin lowering interest rates. Many Fed watchers think that there will be only one .25% or .5% rate reduction this year, however, I believe rates will be reduced by at least 1% to 1.5% this year and at least another 1.5% in 2025. My prognostication is due to the election and the extreme pressure on the Federal Reserve to lower interest rates to benefit the current administration. Investors who buy today at a 6% or 7% cap rate will derive the benefit of lower rates and cap rates when the property is sold in a few years or buying low and selling high.
Joseph J. Ori is Founder and CEO of Paramount Capital Corporation, a Commercial Real Estate Advisory Firm
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