CRE Show host Michael Bull thinks a cap rate increase is inevitable.
Few CRE professionals study the industry as religiously as Michael Bull. The CRE Show host and founder of Bull Realty has made a lifelong habit of monitoring trends over time, investigating the source of industry shifts, and distilling his findings into actionable takeaways and predictions for his weekly audience of over 100,000 listeners.
His latest forecast? Cap rates are about to rise.
Capitalization Rates in a Nutshell
A surprising number of commercial real estate investors have an inadequate understanding of cap rates and how they impact property values. Seasoned industry veterans, however, know that cap rates are crucial to a property’s overall valuation. In fact, CRE insiders typically rely on cap rates more than they do on gross rent multipliers in assessing a property’s value.
While investors should make a point to understand the many intricacies that impact rates and their fluctuation, cap rates are, on the most basic level, calculated by dividing a property’s net operating income (NOI) by its cost. The NOI is calculated by subtracting operating expenses from a property’s annual gross income. Commercial real estate investors (buyers) are looking for high cap rates, meaning that the value or purchase price of the property is low. Conversely, building owners (sellers) want to see a low cap rate because that drives up the price of sale.
Because cap rates are calculated based on current market value, they can vary greatly in accordance with changing market conditions. For example, over the past 12 months, the value of many industrial properties in Southern California has increased due to inventory shortages and growing demand. If property owners don’t increase rents to keep up, their cap rates will decrease considerably. Of course, owners are often unable to adjust rents to match market changes — especially when they unfold within the span of an agreed-upon lease term with their tenants. So it’s on property owners to watch these changes carefully and anticipate industry patterns before it’s too late.
Michael Bull Weighs In
In our recent conversation with Michael Bull, we asked the industry guru what he considers to be the biggest change coming to the CRE industry over the next five years.
“I think a lot of people aren’t anticipating the cap rate changes that are coming,” he says. “I think cap rates are going to rise higher and faster than the industry is anticipating. Lenders are getting more skittish. When you have funding slowing down and interest rates increasing, you’re changing the industry.”
One reason cap rates have remained low in recent years, he noted, is the unprecedented period of low interest rates. But with the Federal Reserve raising its benchmark short-term interest rate in March for the third time since December 2015 and additional rate increases expected by the end of 2017, interest rates are becoming an increasingly relevant factor in analyzing the near-term future of U.S. commercial real estate.
Since the government benchmark used in the commercial real estate market for pricing debt and equity, it stands to reason that the cost of owning properties will rise, and lead to an increase in cap rates — ultimately reducing the value of individual assets for owners and benefitting investors looking to buy.
So how can investors and property owners prepare for these changes? “Principals and property owners could see 10% lower property values in two years. In my view, if an owner is thinking about selling in the next four to five years anyway, I’d sell right now.”
This is not, as Bull made sure to emphasize, a “doom and gloom” prediction. That said, he believes single-tenant, net lease properties will be the most impacted. He explained that those are the “properties with less ability to raise rent.”
While no one can predict the future with 100% accuracy, Bull’s track record and expertise suggest that when he talks, we should all pay attention.
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