Cap rate compression: it’s real, it’s widespread and here is what we think about it

  • First National Financial LP

Despite interest rate increases in the bond market through the last half of 2017 and into the first half 2018 as global economic prospects improve, capitalization rates (net operating income as a percentage of the purchase price) compressed again last year across several asset classes and in multiple urban centres.  Cap rates and property values correlate inversely – as cap rates decline, property values increase, and vice versa.

Market surveys from CBRE and Colliers confirm this trend, which began in the 1990s and accelerated after the 2008 recession. From a national rate of about 10% in 1991, average cap rates across all real estate asset classes fell to just under 6% as 2017 drew to a close (the lowest on record). The trend continued in the first quarter of 2018. As CBRE noted in its Q1 2018 Canadian Cap Rates & Investment Insights report, “Cap rates remained largely unchanged in Q1 2018 with the notable exception being the industrial sector where further cap rate compression is being fuelled by strong rental growth, both actual and anticipated."

Some of the lowest rates have been experienced in the apartment sector with high-rise Class A buildings recently commanding 3.96% and Class B selling at 4.52% as investors bid up properties, particularly in large urban centres like Vancouver, Montreal and Toronto. As a result, apartment cap rates in the GTA have moved closer to those in Vancouver, a city that has long held the sectoral title for lowest rates in the country.

Compression is also evident in the industrial sector and for the reasons noted above. CBRE suggests national industrial cap rates of between 5.31% and 6.31% for A and B class industrial properties, down from 2017 and 2016.

In various forms of retail, CBRE noted that "modest cap rate declines in some… categories belies the over-arching retail apocalypse." To wit, on a national basis, regional retail cap rates in Q1 2018 stood at 5.22%, power centre cap rates were 6.02%, urban storefront was 5.42%, neighbourhood was 6.13%,  strip was 5.81% and high street also remained flat but is still trading tightly at just 3.69%. While for the most part, retail cap rates were unchanged from Q4 2017, the exception was in Montreal where demand for retail assets, particularly in urban submarkets, is currently strong, according to CBRE.*

Cap rates for downtown Class AA and A office properties recently fell to 4.81% and 5.63%, respectively, from a year ago, while hotels have traded anywhere between 7.28% and 8.34%, depending on location and type.

All things considered, low cap rates have been a feature of the real estate market for several years now.  The consequence has been higher prices for most asset classes.  Astute observers will monitor changes in cap rates as interest rates in the bond market vary over time.

For industry analysts, cap rate compression in the face of higher interest rates represents a disconnect since the two have historically moved in the same direction, although not on a one-for-one basis and not always in lock step.

While this disconnect may not last long, it sends a strong message that investors consider commercial real estate in Canada an attractive and stable store of value.  Since interest rates seem to have reversed after a long period of decline, the immediate impact on cap rates – and buyer interest - has been negligible.

Paying Up and Getting More

Commercial properties are expensive today. Even assets that seem unattractive still command strong prices. But as long-term investors know, it’s not just what you pay for an asset that matters, it’s what you do with it after the fact.

First National shares this philosophy and works with many buyers who acquire assets in the current robust pricing environment but have a clear strategy to increase value by growing net operating income. Often times, this involves a repositioning or turnaround strategy that is geared to realizing higher net income and, consequently, higher property valuations.

Despite the fact that repositioning an asset is a viable option for certain properties, there are still opportunities with many properties to purchase the cash flows and “clip coupons.”

Since cap rates determine property value on income-producing real estate, to a large degree, it is important to understand the factors that impact cap rates, valuations and loan amounts.  First National is able to provide reliable data on this property metric to clients so that informed decisions can be made.

*Q1 2018 Canadian Cap Rates & Investment Insights

For more data and information on property repositioning strategies, please speak to your First National advisor.