Most Generation Xers will remember that the greatest innovation in video gaming in the late 1970s was the Atari 5200. It was the first mass-marketed gaming system using cartridges that allowed you to switch games easily and to get a steady parade of new titles. I always reverted to what I considered the old-school classics: Space Invaders, Missile Command and the granddaddy of them all, Breakout.
Breakout was great because of its simplicity. You were given a ball and a paddle with which to break through a brick wall. The key wasn’t to pick away at each brick one by one, but to build a tunnel on the side of the screen so your ball could jump along the top and destroy bricks from the top down. This allowed you to rapidly rack up points without doing much following the initial breakout.
My memories of playing Breakout were jogged by our latest H1 2019 Cap Rate Survey. Cap rates were relatively stable across property types in H1, with slight compression in the office, industrial and multifamily sectors, and slight upticks in the retail and hotel sectors.
Taking a longer-term view of cap rates, most of commercial real estate had been like Breakout until about four years ago. After the hard work of breaking the bricks to improve a property’s value (fundamental improvement), developers were able to break out and watch the ball bounce along the top (cap rate compression) without having to do much more. Then somebody hit the pause button in the first half of 2015 (or maybe my mom kicked the plug again as she was wont to do when I played too long!).
Except for some very modest compression in the industrial and Class B and C multifamily sectors, most cap rates are relatively unchanged from four years ago. Only the retail sector (notably high-street and power centers) has seen significant cap rate expansion during that time. Is it “game over” for cap rate compression and are we now on the verge of a breakout for higher cap rates? I believe we are on the verge of a breakout, but not necessarily toward higher cap rates.
The two key drivers of cap rates are the cost and availability of capital and the fundamental improvement or deterioration of properties. I believe the cost of capital will continue falling as the combination of an aging demographic (increased savings rate) and relatively lower returns in stocks and bonds increase the move of big money into commercial real estate. This will also lower interest rates.
Prime cap rates are now almost equal globally once adjusted for inflation and I believe this trend of U.S. cap rates falling in tandem with prime EU cap rates will continue. Most forecasts are being redone to show that, rather than increasing, long-term interest rates will stay low and short-term rates will likely get lower over the next few years. I wrote about why investors should lower their exit cap rate assumptions before the most recent big drop in long-term interest rates.
Fundamental risk (short term, CRE specific) and not capital risk is where the cap rate expansion or contraction story will be told. We have already seen this in high-street retail, in which many investors were overly optimistic in their rent growth assumptions. We are increasingly seeing that risk in commodity office, where the combination of base-building capital expenditure and tenant-improvement allowances may pose the single greatest threat in commercial real estate values today. Using suburban office as a proxy for commodity office, after showing the same cap rate compression since 2015 as the other asset types, they are inching back up to where they were in 2012.
Owners adjust to these fundamental changes in two ways. First, they take their best assets to market. Based on CBRE’s proprietary Deal Flow predictive analytics, we are seeing deals being brought to the market this year with average cap rates that are 20 bps lower than last year. Second for those assets that are facing fundamental challenges, to the extent owners do not have an exploding capital structure (high debt payments, no ability to refinance/work out), owners will adjust their capital plans by either bringing in a new partner to lower their cost of capital or wait it out.
In short, we are not going to see a flood of higher cap rate deals hit the market because owners will be as patient as possible to sell. Debt capital structures in 2019 are not nearly as stressed from an LTV or cost-of-capital standpoint as they were from 2006 to 2008 period. Even then, we did not see a flood of distressed assets.
Average cap rates will be further bolstered by multifamily and industrial where lengthening leases counterbalance some of the weakness in other sectors. In short, cap rates will be flat to down overall.
The fight between lower-cost capital and fundamental changes is on like Donkey Kong and I believe that overall lower-cost capital will prevail. Are cap rates preparing for a breakout? Yes, and that breakout may be for another round of cap rate compression.
By Spencer Levy, Chairman & Senior Economic Advisor, Americas Research, CBRE.