Discussion: when will triple net cap rates begin increasing?
As interest rates are raising , shouldn’t Cap rates for properties follow the trend? I search loopnet for a while and all I see is ridiculously low cap rate properties under contract. After calculating it , 20% down on a 30 year mortgage would result in you actually losing money each month with most of these properties that are under contract ; with this new marked interest rate that is. I’m slightly new to this so maybe I’m missing something , would appreciate insight and answers!
[{"id": "i2vu1ik", "text": "Good question....we asked the same question back 2016-2018....and CAP rates actually decreased as loan rates increased. I'm not sure looking at loan rates matter considering many of these types of assets are being purchased without financing.", "replies": [{"id": "i2vup6l", "text": "Thanks so much for the info. Well if you wanted to purchase a triple net lease , would you purchase it full outright with cash? Or does it make sense to take out a traditional 30 year fixed loan with like 20% down? I\u2019d assume because the safety of it and easily projectable amount you\u2019d make in rent , you can just take out a loan and pay it off ; building equity and keeping any profits monthly.", "replies": [{"id": "i2yxm9i", "text": "Are you attempting to buy leases?", "replies": [{"id": "i2z3a2i", "text": "I\u2019m way too young and short on capital to do so ; I can\u2019t even legally take out a loan yet. But I\u2019ve just been exploring methods to make money if I theoretically had decent capital and buying properties with long leases appeals to me due to how long term and predictable they are. Only issue is I have no clue how the financing on triple net properties work but that\u2019s been explained to me", "replies": [], "depth": 4}], "depth": 3}, {"id": "i2zca4l", "text": "Hypothetically, sure. I don't do very much STNL, but generally the problem you have is that right now there are a lot of people trying to park cash somewhere, and there's not much good supply for any asset type right now. It's just a really competitive market.", "replies": [], "depth": 3}], "depth": 2}, {"id": "i2vv540", "text": "This. I see most of my clients trying to beat inflation by purchasing income producing assets that they can hold long term. Property values need to take a big hit before we see cap rates going up again.", "replies": [{"id": "i2vx3jp", "text": "Do you believe these interest rate hikes that we are expected to see soon may induce that crash?", "replies": [{"id": "i2x51p9", "text": "If not a crash, a downturn.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "i2zdhqt", "text": "Had this convo with a bunch of people at ICSC Dallas yesterday. There is so much cash out there, lending rates are damn near irrelevant to Cap rates. I think in about 6 months, if inflation keeps creeping, it will finally start seeing a little pressure on caps if we are lucky. Talked to one guy who bought a stabilized 2 cap this month lol", "replies": [{"id": "i30wqpy", "text": "2 CAP! Damn, that is brutal. I am seeing In N Outs trading for at least 3.5% or so...But I do have an off market Target for 3%...", "replies": [], "depth": 3}, {"id": "i5uou95", "text": "I was at Icsc Dallas a few weeks back as well! Good to have the Icsc shows back. \n\nIf you\u2019re going to the Vegas show next month, hit me up.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "i2w870z", "text": "Mortgage rates do NOT directly affect cap rates, that\u2019s why there\u2019s no correlation.  Cap rate is determined by taking the Net operating income (NOI) and dividing it by the current market value of the asset.\n\nCap rate = NOI / Market value\n\nAs Market values increase across the board for most real estate the cap rate will actually decrease, provided there\u2019s no change in NOI (which makes sense on a long term lease with fixed rental rates).", "replies": [{"id": "i2w9b6e", "text": "This is wrong from both economic and financial perspectives. \n\nA cap rate is a terminal discount rate applied to next years cash flows generated by the subject property. \n\nAlso, while the correlation isn\u2019t 100%, there is a soft correlation between cap rates and real interest rates. \n\nhttps://www.cbre.com/en/insights/reports/why-do-real-interest-rates-matter-for-real-estate", "replies": [{"id": "i2wd8uq", "text": "I appreciate the article and it\u2019s interesting but OP asked why cap rates weren\u2019t increasing with interest rates.  Fundamentally, from a financial modeling/valuation standpoint, since NOI excludes debt service the interest rate changes are irrelevant in a fixed lease scenario.\n\nI recognize there\u2019s a soft correlation over time, but looking at a short term snapshot where net income is unlikely to change quickly (and in long term industrial leases with credit worthy tenants rental increases are typically fixed at a low sub 2-3% rate in my experience) you wouldn\u2019t see any immediate correlation since interest rates will move quickly and these leases could easily be 7-10 year terms.", "replies": [{"id": "i2wj6j6", "text": "Interest rates changes matter, because as the back end of the curve feels sympathy and caps stagnate, money flows elsewhere. This reduces the value of the property and causes prices to drop, which in turn expands the cap. Edit: I think OP is focused on the denominator, and you are talking about the numerator.", "replies": [], "depth": 4}, {"id": "i2wnqjx", "text": "&gt;Fundamentally, from a financial modeling/valuation standpoint, sinceNOI excludes debt service the interest rate changes are irrelevant in afixed lease scenario.\n\nThis is a common misconception. Cap rates do take into account debt.\n\n&amp;#x200B;\n\nA cap rate is synonymous with a terminal discount rate. Terminal discount rates are found by subtracting a long-term growth rate from your WACC. WACC takes into account debt. Because cap rates are a form of terminal discount rate, and discount rates take debt into account, it logically follows that cap rates take debt into account.\n\n&amp;#x200B;\n\nHere's a good example: Class B Multi-Family Value Add deals in the southeast trade at 4-5% caps. How does the market get to this number?\n\n&amp;#x200B;\n\nLet's consult our terminal discount rate which is given by:\n\n    m (terminal discount rate) = r (discount rate) - g (long term growth rate)\n\nSo we solve for discount rate:\n\n    r = (cost of debt * weight of debt) + (cost of equity * weight of equity)\n\nOn such a deal, you can typically get a 25 year AM, at a 3.75% fixed rate, with an LTV of 65%. With these terms, your \"cost of debt\" (payment divided by loan amount) is 6.2%. Your equity will typically require a return of 8%. This is the pref hurdle for several REPE funds. So our discount rate is:\n\n    6.85% = (6.2% * 65%) + (8% * 35%)\n\nLastly, we have our long-term growth rate. This number typically fluctuates from 1-3%, with hotter markets being closer to three. Because these deals are cooling off, many underwrite 2.5% for the long-term growth rate. Now we find our terminal discount rate, which will end up being our cap rate.\n\n    4.35% = 6.85% - 2.5%\n\nAs I stated earlier, this terminal discount rate is in the 4-5% range.\n\n&amp;#x200B;\n\nAs for this part of your comment:\n\n&gt;you wouldn\u2019t see any immediate correlation since interest rates willmove quickly and these leases could easily be 7-10 year terms.\n\n&amp;#x200B;\n\nWhile it's true you may not see an immediate change in cap rates, there certainly is something happening behind the scenes of real estate asset pricing, even if it doesn't come to the light right away. In my example, if I change the terms from a 3.75% to a 4.5% interest rate, it would find a terminal discount rate of 4.7% instead of 4.35%. This is a pretty *meh* difference.\n\n&amp;#x200B;\n\nWhat can really hurt cap rates is if these current \"hot markets\" lose their steam at the same time interest rates rise, which can actually be an effect of interest rates rising.\n\n&amp;#x200B;\n\nIn our example, if interest rates go from 3.75 -&gt; 4.5% **and** the long-term growth changes from 2.5% to 1.5%, now market cap rates should be in the 5.5-6.0% rate. All else equal, this could lead to a loss in property value of 20-30% over the course of a year, depending on how quickly the market reacts.\n\n&amp;#x200B;\n\nI'd like to add that I think it's highly unlikely that we see some doomsday scenario with rising interest rates, I just think it's important not to dilute the significance of rising interest rates.", "replies": [{"id": "i2wycdk", "text": "The question is posed in a commercial real estate forum which implies retail, office, and industrial.  Multi family is residential and therefore certainly considers different variables, which is interesting since your analysis refers to weighted average cost of capital which wouldn\u2019t apply to an individual investor who has no issued equity to draw against.  His cost of capital is going to be solely what a bank can lend to him.  Moreover, his risk tolerance may be far different than an institutional investor with a shorter investment horizon.\n\nNevertheless, if you can show me a formal financial valuation model that specifically incorporates debt service into the actual Cap Rate formula then I\u2019ll gladly retract my statement.  However, it appears we\u2019ve veered far off course from OPs original question asking why interest rates aren\u2019t moving cap rates in commercial properties with an existing lease.  \n\nI agree with some of your other statements, by the way, about how interest rates will move cap rates indirectly but that was not the original question asked.", "replies": [{"id": "i2xcv9a", "text": "It\u2019s called the band of investment formula and is pretty standard in appraisal income capitalization approaches.", "replies": [], "depth": 6}, {"id": "i3dwgk3", "text": "Multifamily is not residential, it is absolutely commercial. And WACC does apply to individual investors. You set your own expected return. \n\n&amp;#x200B;\n\nAs for the \"formal financial valuation model\", I think you may be misunderstanding my perspective. \n\n&amp;#x200B;\n\nYou are correct, the formula NOI / Purchase Price does **not** take debt into account. However: NOI / Cap Rate **does**. A Cap Rate is a valuation metric, as others have stated. You should derive your cap rate rather than back into it with a purchase price, and I have given a way to come to a sound cap rate for an investment, AKA, a terminal discount rate. \n\n&amp;#x200B;\n\nAnd yes, we have gotten off course, but I think the discussion shows OP how there is much debate around this subject.", "replies": [], "depth": 6}], "depth": 5}, {"id": "i2x7237", "text": "This is a very accurate and well explained answer. I\u2019m in the industry and in the market everyday, and agree with your response.", "replies": [{"id": "i2yy9xs", "text": "And I play a RE Developer online (and occasionally a barista and a trombone player), and I also find this answer well explained and accurate.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "i2yxztg", "text": "&gt; interest rate changes are irrelevant in a fixed lease scenario.\n\nAre you high?", "replies": [{"id": "i2yzrfi", "text": "If you negotiate a lease on the front end you determine the term, the starting rental rate, and any annual rental escalations.  Over the term of the lease your payments are therefore known and unchanging (assuming fixed escalations), whereas floating escalations are usually tied to CPI.  Again no direct impact on the rent you pay the landlord during the term of that lease in base rent.  So no, not high, thanks.", "replies": [{"id": "i2z03rx", "text": "WTF does that have to do with cap rates?\n\nSet the crack pipe down.", "replies": [{"id": "i2z160o", "text": "I\u2019m merely responding to your question suggesting that fixed leases are impacted by interest rate changes. By virtue of their terms being \u201cfixed\u201d over some period of time I\u2019m merely asserting that interest rates would have no bearing on rent. \n\nWill rate changes affect lease renewal? Probably as the market rents may change thereby impacting tenants renewal option pricing or what landlord seeks to get to balance their cash flows.  But again that\u2019s an impact AFTER the current lease ends.\n\nAs to the question of cap rates if your rental income is known then your net operating income can be easily calculated (assuming some placeholder value assumption for any repair and maintenance costs). Since net income can therefore be calculated with a high degree of certainty, and value is known (by virtue of OP saying these are under contract properties meaning the value assigned will be the sales price) then you can determine with certainty the cap rate.  Again since interest doesn\u2019t impact net income in this scenario and the value is unchanging the cap rate will NOT be affected by interest rates.", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "i2wzwhf", "text": "You should stick to practicing law as you don\u2019t have a clue.", "replies": [{"id": "i2x0t08", "text": "Fine, don\u2019t take my word for it, here\u2019s an independent piece talking about the numerous variables outside of just interest rates that would affect cap rates in multi family real estate since that seems to be y\u2019all\u2019s focus:\n\nhttps://www.principalglobal.com/documentdownload/142008\n\nInteresting to note that multiple times he states cap rates are not significantly tied to interest rates especially when noting the spread and lag between treasuries and cap rates. Just like I said above it\u2019s not directly correlated. I\u2019m not wrong and you are all answering divergent issues that don\u2019t specifically respond to OPs initial question.", "replies": [], "depth": 3}], "depth": 2}, {"id": "i2x059o", "text": "Stick to practicing law. You are clueless!", "replies": [], "depth": 2}], "depth": 1}, {"id": "i2w9mtb", "text": "From a small-guy perspective, I'm in the thick of it right now with lending getting a little weird. Had a community bank refuse to honor a term sheet just before close due to the rise in treasuries, even though that anticipated rise was supposed to have been baked in up front. In the end they wouldn't accept any compression of their spread. Back up lenders are accepting that compression but it is unclear to me for how long they can do so. \n\nDifferent perspective: a regional bank president (separate from above) told me recently that treasury rates won't really impact their lending, at least not until they are forced to raise depository rates. His words, \"We're swimming in cash like many other banks, and we still need to place it.\"", "replies": [{"id": "i2xixog", "text": "This almost happened to me, lender trying to back out of term sheet interest rate because of a rise. Fortunately they agreed to honor it after some push back. How did you deal with this?", "replies": [{"id": "i2xpemi", "text": "It's a total cluster rn. Pushed back hard from multiple angles and relationships to no avail. Got a 45 day extension and underwriting with new lenders. Luckily seller is friendly and wants it done. Good news is that I think it will turn out ok with actually better rate and term from the newly referred lender, but we have to keep riding the wave and hope this one holds. \n\nIf this fails then I missed the window bc I chose the wrong horse in Jan, and I'm basically SOL until debt or properties reprice. At certain spreads the reward is too small to take on leverage, IMO.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "i2y40j1", "text": "High inflation rates mean that rents are also escalated. Usually commercial rents are indexed to cpi or another inflation factor so you wouldn\u2019t necessarily see any impact on the cap rate of an individual asset.", "replies": [], "depth": 1}, {"id": "i2y6nic", "text": "Haven\u2019t read other responses, but they already are in the short term. My team is currently in the market with several of these assets. On any long-term leased asset (especially with &lt; 3% rent bumps) we\u2019ve seen roughly 50 bps of cap rate expansion mostly driven by the widening debt spreads. Ex. Credit tenant has a 10-15 year lease with 2% rent bumps - was pricing &lt;4% cap in decent markets, now looking like a 4.2%+. Likely isn\u2019t changing anytime soon unless interest rates or spreads tighten back up. Happy to provide additional color if anyone wants to DM", "replies": [], "depth": 1}, {"id": "i2ys8yc", "text": "It\u2019s a supply/demand issue that is keeping cap rates compressed currently.  While logic says cap rates should rise by about 40 bps immediately due to shifts in interest rates, you still have funds that have hedged their interest rate risk for the year and plenty of 1031 Buyers willing to pay all cash. If inventory levels rise and buyers have options again, then rates will rise. If inventory stays low due to lack of new product being developed then the rise in cap rates could be very delayed.", "replies": [], "depth": 1}, {"id": "i2yxi1s", "text": "*\"After calculating it, 20% down on a 30 year mortgage would result in you actually losing money each month with most of these properties that are under contract ; with this new marked interest rate that is.\"*\n\nReal estate investing has risk.  It's where adults play.", "replies": [], "depth": 1}]