Cap Rate Update: Compression Continues and Here is What We Think About It
Capitalization rates (net operating income as a percentage of the purchase price) remained low and in some markets/asset classes compressed again in 2018, suggesting that property values continued to increase.
Market surveys from CBRE and Colliers confirm that cap rate declines/compression is a trend that began in the 1990s and accelerated after the 2008 recession. From a high of almost 10% in 1990, national average cap rates have declined. With a couple of notable exceptions (described below), cap rates fell to under 6% in 2018.The spread between national average cap rates and yields on 10-year Government of Canada bonds stood at 367 basis points compared to 465 points seven years ago*. (Astute observers will monitor changes in cap rates as interest rates in the bond market vary over time.)
Apartment Cap Rates Compressed
Some of the lowest cap rates have been experienced in the apartment sector with high-rise Class A buildings recently commanding 3.91% and Class B selling at 4.45% as investors bid up properties. (By comparison, cap rates a year ago for these asset classes were 3.96% and 4.52%, respectively.) Regionally, Vancouver continued to hold the sectoral title for lowest apartment cap rates in the country, followed by Toronto, Ottawa and Montreal.
In its 2018 fourth quarter commentary, CBRE stated that "the stability of the sector has become increasingly enticing for investors given recent financial market volatility, economic uncertainty and increased liquidity, which has placed significant upward pressure on pricing. Cap rates in this sector continue to be the lowest of any asset class in Canada and investors are increasingly open to sacrificing going-in yield in exchange for the possibility of future rent growth."
Industrial Cap Rates Compressed
Compression is also evident in the industrial sector. CBRE suggests national industrial cap rates of between 5.17% and 6.16% for A and B class properties, down from 5.31% and 6.31% a year ago.
CBRE noted that cap rates for "Canadian industrial assets continued to trend downward due to a scarcity of properties reaching the market, further strengthening fundamentals across virtually all geographies and growing distribution and logistics requirements fueled by increases in e-commerce penetration."
Retail Cap Rates Were Mixed
In retail, cap rate movements were mixed and generally reflected shifting investor tastes that were informed by changing consumer consumption patterns. For regional retail assets, cap rates were stable at 5.23% as the year came to a close (compared to 5.22% a year ago); cap rates for power centres increased to 6.19% (from 6.02%); urban streetfront cap rates compressed to 5.34% (5.42% a year ago); while neighbourhood and highstreet both increased to 6.25% and 3.81%, respectively, from 6.13% and 3.69% a year ago. Geographically, Vancouver had the country's lowest cap rates in every retail sector except neighbourhood: Victoria took that title. The biggest change was witnessed in Quebec City: cap rates for regional retail assets declined 100 basis points quarter over quarter in Q4 2018.
Hotel and Office Cap Rates Were Mixed
Cap rates for hotel properties fell in 2018 to a range of between 7.08% (downtown full service) to 8.20% (suburban limited service) compared to 7.28% and 8.34% a year ago. Office cap rates, meantime, were stable (downtown Class AA and A office properties were 4.81% and 5.63%), a result CBRE attributed to "strong leasing fundamentals coupled with high rental rate growth expectations…"
What is interesting about the market data noted above is that cap rate compression was experienced in spite of three separate (though small) increases in the Bank of Canada bank rate in 2018. Although that rate increased, bond market yields declined starting in November 2018 and continuing into 2019. This anomaly has been remarked upon by market commentators who referenced a flat or inverting yield curve.
As CBRE noted in its fourth quarter Canadian Investment Trends: "While rising interest rates remain a point of note, the late-year cooling of the bond market seems to have extinguished upward pressure on real estate cap rates for the time being."
While it's far from clear if the BoC will raise rates again 2019, the overall message sent by recent cap rate movements is that investors still consider commercial real estate in Canada an attractive and stable store of value.
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.
For more data and information on property repositioning strategies, please speak to your First National advisor.
*CBRE - Q4 2018 Canadian Cap Rates and Investment Insights – Page 3.