By Salvatore Bruno via Iris.xyz
Capitalization or “cap” rates are a key metric in determining the potential rate of return of commercial real estate, as well as for ETFs and mutual funds that invest in the asset class. They equate broadly to yield, a key consideration for income-oriented real estate investors.
Cap rates are determined by dividing a property’s net income by its market value. High cap rates indicate a good return on investment, but of course they can also signal more risk. Cap rates tend to decline – become compressed, as they say in the industry – the longer the real estate cycle goes on, as prices for properties are bid up and returns go down.
To make things more complicated, you can’t really calculate a single cap rate covering all of commercial real estate. Cap rates vary by property type, as do returns. So cap rates for office properties can be low while those for industrial or multi-family can be high, and vice versa. We are now well into a period of recovering real estate values, so what are cap rates saying now about the asset class?
The short answer is it depends. For example, cap rates for retail were up 10 basis points in the second quarter, a significant jump, according to a recent story in National Real Estate Investor.1 Some types of retail properties are doing better than others, in particular those that avoid direct competition with Amazon, and standalone businesses like medical clinics and quick food restaurants have also been doing well. Malls, on the other hand, have been under pressure.
While areas of retail have suffered, industrial has been a major beneficiary of the move to online shopping, with distribution facilities being built all around the country to meet growing logistical demand. This has led to a slight decline in cap rates nationally, from 5.6% in mid-2017 to a more recent 5.4%, according to Cushman & Wakefield.(2)
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