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, declined slightly during the fourth quarter. This was not even a 10-basis-point decrease, but nonetheless pushed the average cap rate down to 6.4%. It still appears, at least at this juncture, that cap rates can’t seem to punch much lower than their current levels. The mean cap rate hit a post-recession low of roughly 6.2% in the first quarter of 2013 but has been hovering slightly above that level since then. If we look at the 12-month rolling cap rate, shown as the red line in the graph, this supports the notion that cap rates for apartment appear to be a bit stuck. The 12-month rolling cap rate was virtually unchanged at 6.4%. Of course, apartment cap rates are back to levels that were observed before the recession. Although we anticipate that vacancy rates will stop declining this year, the overall environment should be supportive of declining cap rates in the future. Economic growth will accelerate, household and population growth will ramp up, and risk premiums should decline. However, most of the cap rate compression that was anticipated has already occurred. From this point forward, expect any further compression to be only modest.
Office Market Cap Rate Trends
During the fourth quarter, the mean office cap rate increased by roughly 30 basis points to 7.1%. This brings the mean cap rate back to where it was a year ago, and continues the bumpy ride for office cap rates – downward, but not consistently so. With the transactions market focused primarily on high-quality assets in good markets, the volume is not only shallow, it is concentrated. This is producing a cap rate trend that is more volatile than that of apartment, which is characterized by a deeper and more widespread transaction environment. 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, certainly greater compression than we anticipate in the apartment sector over the next five years.
Retail Market Cap Rate Trends
Retail cap rates have also lost momentum over the last year. During the fourth quarter, the mean cap rate increased slightly to 7.7%. This makes it the major property sector with the highest average cap rate, 60 basis points higher than office and 130 basis points higher than apartment. It is now virtually unchanged over the last year and down only 40 basis points over the last two years. Nonetheless, the mean cap rate is now down 230 basis points since it peaked during the second quarter of 2009. While retail has barely recovered over the last two years, it was also hit the hardest when the economy was imploding, so it has further to bounce back than the other property sectors. The average apartment cap rate never rose above 7.4% while the average office cap rate never rose above 8.2%. If we look at the 12-month rolling cap rate we can see that it too has flattened out, more or less level since late-2011. Yet, it is also down near pre-recession levels. The good news is that cap rates are projected to fall over the next five years. All of the major factors that drive retail sales are projected to grow over the forecast period – GDP, the employment market, and household incomes are all projected to increase at healthier paces over the next five years than they have grown at over the last five years. And as we mentioned last quarter, current levels of real spending are roughly $800 billion (on a real basis) below where the long-term trend predicted they would be. At some point, spending will revert back to the long-term growth trajectory. And while the media has made much of how this recession has impacted the behavior of younger consumers in the economy, many consumers will be all too happy to return to their profligate spending once the economy and labor market are more accommodating. And what about mighty ecommerce? Without downplaying its risks, it is important to remember that only 6% of overall sales occurs via ecommerce. Even as that percentage grows over time, the majority of sales will continue to take place in physical stores. This will drive demand and cause fundamentals to improve. What investors will absolutely need to be careful of is differentiating between sectors that are currently suffering from a cyclical impairment as opposed to those suffering under the unyielding weight of structural impairment. In the case of the former, those centers will bounce back and present investors with compelling opportunities. In the case of the latter, it is often difficult to restore one’s former glory in the retail sector. Be careful out there.