Apartment Cap Rate Trends
The mean cap rate, calculated on a dollar-weighted basis by quarter, declined by 20 basis points during the first quarter to 6.3%. After rising very slightly during 2013, the mean cap rate is now back near levels from late 2012 and early 2013. The mean cap rate hit a post-recession low of roughly 6.2% in the first quarter of 2013 but has hit a bit of a floor since then. If we look at the 12-month rolling cap rate, this also indicates that cap rate compression in the apartment sector has run out of steam. The 12-month rolling cap rate was virtually unchanged at 6.4%. Nonetheless, cap rates for apartments remain the lowest of the major property sectors, reflecting the strong appetite for this property type from investors. For the remainder of the year, the overall environment should be supportive of declining cap rates. However, any further compression in cap rates from this juncture will be slight – with prices already so high for good-quality assets, cap rates simply do not have much farther to fall.
Office Cap Rate Trends
During the first quarter, the mean office cap rate decreased by roughly 40 basis points to 6.8%. This is the lowest mean cap rate for the office sector since before the recession. Though it has been an inconsistent ride, the mean office cap rate has now fallen by approximately 150 basis points since it hit a post-recession high of 8.3% during the first quarter of 2010. Of course, transaction activity remains concentrated in a few primary gateway markets, focusing on A-quality assets. Over the next five years we expect that office cap rates will continue to trend downward. As the economic recovery gets deeper and broader, interest in the office market should become far more pervasive than it is today. This should translate into continued cap rate compression, though like apartment, most of the compression in cap rates has likely already occurred. As transaction activity in the office sector spreads to a greater number of markets and a wider array of property classes, this will limit cap rate compression as these deals are likely to have higher cap rates (in some cases far higher) than the majority of deals which are transacting today.
Retail Cap Rate Trends
Retail cap rates are also generally trending downward, but at a far slower pace than that of apartment or office, and the path downward continues to be inconsistent. Evidence of this inconsistency comes from the first quarter data. During the quarter, the mean cap rate increased by 30 basis points to 7.9%. Retail remains the major property sector with the highest average cap rate, 110 basis points higher than office and 160 basis points higher than apartment. This is largely due to the lagging improvement in fundamentals. There are still investors interested in retail deals, but it tends to be a shallow pool, characterized by smaller deals and higher-quality assets. The mean cap rate for the retail sector is now well below its peak from the second quarter of 2009. However, after some relatively strong initial compression, it appears that reality set in and most investors realized that this was going to be a tough, long slog of a recovery for retail. If we look at the 12-month rolling cap rate we see more evidence of the loss of momentum in cap rate compression, with rates flattening out since late-2011.
Cap rates in the best markets remain at very low levels. Markets with the lowest cap rates are generally in the 3.5% to 5.0% range across sectors while markets with the highest cap rates are generally in the 9.0% to 11.5% range. What is interesting about this is that with little variation at the top and bottom of the market, it intimates that most of the variation that we are seeing in cap rates across sectors must be coming from the middle of the market, in that grey area between the high-end, high-quality deals and markets, and the low-end, low-quality deals and markets. This agrees with selection bias in the market that we have observed in recent years. Investors have been willing to invest in high-quality deals with sound investments theses. They have also been willing to tackle distressed deals that have relatively little downside risk and offer the enticing potential of huge upside and outside returns. In between these two extremes, investors are less certain, so they have a tendency to heavily scrutinize deals. With fundamentals across the major property sectors proceeding at different paces, this is manifesting itself in between the extremes of high- and low-quality investments. The apartment sector recovery is strong, so cap rates in the middle of the market are lowest, followed by office, with retail lagging. This makes perfect sense – at the extremes, the investment thesis is well understood. In between extremes, the story is not as clear and the impact of fundamentals on pricing is noteworthy.