In this graph we observe that the mean cap rate, calculated on a dollar-weighted basis by quarter and illustrated by the blue line in the chart, inched up again during the third quarter. This was not even a 10-basis-point increase, keeping the rate virtually unchanged at approximately 6.4%. But it reinforces the notion that the market has hit a bit of floor – the mean cap rate appears to have skipped off the bottom over the last couple of quarters. Meanwhile, the 12-month rolling cap rate, shown as the red line in the graph, also increased by less than 10 basis points to around 6.4%, on par with the mean cap rate. This also appears to indicate that the market has hit a bottom, at least temporarily. This is likely just some pricing fatigue on the part of the market – cap rates stand at rates that were last seen before the recession. This is most probably just a respite and not a true reversal. With the economy likely to accelerate over the next few years, we anticipate that cap rates will continue to fall. However, because we have already seen much compression in cap rates since 2009, any future compression will be far more gradual.
Office Market Cap Rate Trends
During the third quarter, the mean office cap rate fell by roughly 10 basis points to 6.9%. This remains the second lowest cap rate that we have observed since the third quarter of 2008 when it stood at 6.4%. Yet this cap rate compression has arrived without the benefit of widespread improvement in office fundamentals. Thus far, the recovery in office fundamentals is really concentrated in a handful of technology- or energy-oriented markets. What happens when the fundamentals recovery finally spreads across a wide swath of metro areas? This will help to push office cap rates down even further over the next five years. As the economy continues to recover, demand will spread beyond just a couple of key office-using sectors of the economy into other national and local industries. With supply growth expected to remain largely in check, cap rate compression over the next five years will be comparable to the compression that we have seen over the last four years. That stands in stark contrast to the apartment sector where cap rate compression should continue, but only modestly.
Retail Market Cap Rate Trends
This quarter provides more evidence that retail cap rates have hit a floor, even if it is temporary as we expect with the apartment sector. During the third quarter, the mean cap rate for retail increased 10 basis points to 8.0%. The figure remains more or less unchanged over the last two years, moving within a narrow range of 7.8% to 8.2%. Somewhat surprisingly, cap rates are still lurking near levels that we observed before the fall of Lehman Brothers in September of 2008. This is surprising because this is the property sector with arguably not only the worst recovery in fundamentals thus far, but the weakest recovery yet to come. The 12-month rolling cap rate has been even flatter than the mean cap rate over the last couple of years. It also remains down near pre-recession levels. Yet, we expect cap rates for retail to continue to fall over the next five years. So what’s the story behind our seemingly optimistic forecasts? Is this simply the case of pro-cyclical rebound with the overall economy translating into some improvement in fundamentals which should in turn spur interest in the sector? Certainly, an accelerating economy will produce stronger job growth and stronger wage growth which will serve as a catalyst for retail sales. But that’s only telling part of the story. Real consumer spending today remains depressed in the wake of the worst recession in 80 years. Relative to where spending would likely be today if we hadn’t experienced such a deleterious recession, based on long-term growth in consumer spending, we are down about $800 billion on a real basis. It is not as if all consumers have found religion when it comes to spending during this downturn. While it is impossible to say that none will change their ways in the future, many aren’t spending more money simply because they cannot right now due to weakness in the labor market. When the labor market tightens and job growth and income growth increase, many consumers will return to their old consumer habits. And even if some of that consumption occurs via the Internet, the majority will still take place in bricks-and-mortar retail centers. This will cause fundamentals to improve and present investors with relatively more opportunities in the future than can be found today, providing the impetus for lower cap rates.