GARY J. LEMIRE
Different ingredients

On the surface, it seems akin to lemonade prices rising in January, but the continued low-wire act of capitalization rates despite a difficult commercial real estate sector can be explained, investment sales specialists insist.

“There is no disconnect between market fundamentals and [cap rates],” maintained Torto Wheaton Research Senior Economist Petros Sivitanides, so intrigued by the phenomenon that he last week issued the second of a two-part series exploring the trend. The study tracked recent cap rate activity and also attempts to forecast where the indice is headed during the next five years.

Using appraisal and transactional data from the National Council of Real Estate Investment Fiduciaries and the National Real Estate Index, the TWR analysis confirmed that cap rates have been steadily declining as far back as 2001. Meanwhile, the national office vacancy rate rose from 8.6 percent in the fourth quarter of 2000 to 16.5 percent by year-end 2002, prompting nominal rents to plunge by some 16 percent during that time.

A prime reason for the dichotomy, Sivitanides unveiled, is that cap rates are not solely driven by real estate performance, with inflation and interest rates also contributing to the direction in which they might move. According to Sivitanides, “The downward pressure imposed on cap rate levels by the 40-year record-low interest rate is greater than the upward pressure exercised by the weak market fundamentals.”

In addition, a deeper review of cap rate trends shows that the lowest rates are reserved only for those properties sporting a demonstrated measure of stability, particularly over the near term. The so-called “risk premium,” as cited by the TWR report, revealed that cap rates tend to increase substantially if the asset is in an off location or is a product type that has fallen out of favor, such as hotels and telecommunications properties.

“There are fewer and fewer properties that qualify for the well-publicized [low] cap rates we’ve heard so much about,” concurred CB Richard Ellis/Whittier Partners principal Gary J. Lemire. “The building needs to have great credit, a lot of term and occupancy, and if one of those ingredients is missing, it is going to be hard to attract the kind of interest one needs” to capture a low cap rate.

According to Lemire, the strongest cap rates are currently reserved for grocery-anchored shopping centers, well-located apartment properties and single-tenant, net-leased office buildings. Suburban office assets will be hard pressed to attain a single-digit cap rate, said Lemire. “Up along Route 128, you almost can’t give them away,” he said, with most brokers anticipating that suburban rents will continue to fall for most of 2003.

‘Aggressive’ Underwriting

Cushman & Wakefield appraiser Tyler Brown reports a similar scenario, explaining that commercial real estate has bifurcated into two categories-“financable and non-financable.”

“Even in [strong] locations, people don’t want to buy vacancy right now,” said Brown. On the flip side, he said, investors are clamoring for credit and term. “There’s a lot of capital chasing those deals, and the underwriting is very aggressive, which broadly translates into lower cap rates,” he said.

Geographic considerations are also critical, with apartment properties in the supply constrained Northeast typically garnering lower cap rates than those found in other parts of the country, which annually generate four or five times as many units as those produced in New England. By the same token, certain office markets are expected to outperform Boston over the short run, leading to potential rises in those cap rates locally.

According to the TWR Spring 2003 Outlook, for example, lingering troubles in Boston’s office market should increase cap rates by 170 basis points through 2007, compared to a drop of 57 basis points in Cleveland over that period. “We are projecting some tough years ahead for Boston,” Sivitanides confirmed.

While the Hub faces a particularly onerous road, Sivitanides said investors overall should be more worried about seeing cap rates rise as opposed to falling further in the future. A robust recovery in the real estate markets is not expected, and the most likely direction for interest rates is ultimately upward. Considering those scenarios, as well as the prospect that inflation will remain in check, Sivitanides said he does anticipate cap rates also will be on the increase.

In an industry increasingly subject to intricate financial formulas and overwhelmed by empirical data, it might be easy to ignore the current cap rate movement, but Sivitanides said that could prove disastrous for investors who are purchasing properties at current rates. Given that the cap rate is so tied to an asset’s performance, and the likelihood that they will be on the increase, Sivitanides said TWR is actively encouraging its clients to proceed carefully.

“We are trying to bring attention to this issue,” he said. Investors “have to consider not only what cap rates they are buying into today, but what they are going to be selling into in five years. It is very important they understand where [rates] are headed.”

Joe Clements may be reached at jclements@thewarrengroup.com.