Apartment Cap Rate Trends
The mean cap rate, calculated on a dollar-weighted basis by quarter, declined by 30 basis points during the third quarter to 6.3%. As the mean cap rate shows, apartment cap rates have largely bottomed out. Over the last four years, the mean cap rate has fluctuated within a relatively narrow band of 50 basis points. That’s not to say that cap rates in the future won’t decline a bit more, but the majority of cap rate compression has clearly ended. Additionally, if we look at the 12-month rolling cap rate, this also indicates that cap rates in the market have bottomed out. In fact, if we look at the last five years, we barely find evidence of rising cap rates anymore. The trend in both cap rate series is clearly downward over time. While this appears to indicate that cap rates should begin rising sometime soon, interest rates and cap rates do not correspond in a 1-to-1 fashion. The economy and fundamentals will put continued downward (though modest) pressure on cap rates, at least in the short term.
Office Cap Rate Trends
During the third quarter, the mean office cap rate increased by roughly 10 basis points to 6.9%. Though technically a slight increase, office cap rates remain near their lowest levels since before the recession. Although the compression in cap rates has been occurring for the past four years, cap rates for office (as measured by both the mean cap rate and the 12-month rolling cap rate) peaked after those of apartment so you can still see the throes of rising cap rates in late 2009. If you look at the 12-month rolling cap rate, although there are some indications of a bottom, that analysis is a bit premature. Over the last four years, we have observed periods when cap rates appeared to be flattening, only to continue declining not long after that. That’s likely to be the case here as well. The recovery in demand for office space will accelerate in the coming years. All else being equal, that will make office a relatively more attractive property type for investment. This will cause demand for office investment to increase relative to today, which should put downward pressure on cap rates. However, like apartment, most of the cap rate compression that we would expect to see in this phase of the cycle has likely already occurred. The one noteworthy difference with apartments is that because the recovery in office fundamentals is at an earlier stage than that of apartments, it likely means that the downward trend in cap rates for offices should persist a bit longer than for apartments, which will see fundamentals begin to erode a bit as a deluge of new construction hits the market over the next couple of years.
Retail Cap Rate Trends
The mean retail cap rate during the third quarter declined substantially, falling 80 basis points to 7.2%. That’s the lowest level for the mean cap rate since it fell to 7% three years ago. Looking at the trend over the last five years, that 7% reading during the third quarter of 2011 was clearly an anomaly. Nonetheless, the trend in cap rates for retail is decidedly downward. This is a stark reversal from what occurred over the last couple of quarters when the mean cap rate had risen slightly. This kind of inconsistent pattern was likely to occur. The issue with retail is that it remains a bifurcated market. High-quality properties have no shortage of bidders and command low cap rates. Poorer-quality properties trade, but the bidding is not nearly as competitive and the cap rates are relatively high, reflecting the poor current state and outlook for retail properties that are not dominant in their respective markets. Consequently, it doesn’t take very much to cause cap rates to fluctuate. Just a handful of good or bad properties traded in a given quarter can cause results to be volatile. That’s what we observed during quarters such as this one or the third quarter of 2011. Although this issue of have and have-not properties has always existed, the rift between them in terms of performance and cap rates is wider than it normally is. With the majority of households still struggling and not participating in the economic recovery, many retail centers that cater to such households are also struggling. That is not likely to change much in the near future. Even as some investors take a chance on these centers, they will continue to command high cap rates. Meanwhile, good, dominant centers that cater to affluent households will continue to fare well (as will their customers) and command low cap rates. Therefore, expect this bifurcation to continue. Even as the overall economy recovers the benefits will still largely accrue to a small percentage of the population that has discretionary income. This will be reflected in retail cap rates. The trend will remain downward for the next few years, but the spread between the cap rates of good and poor retail centers will not converge too much.