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Rising Inflation, Interest Rates Could Spur Cap Rate Increases

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Rising interest rates and an uptick in inflation have some wary of upward cap rate movement this year. 

Cap rates were relatively static in 2017. While the industrial and multifamily sectors saw some cap rate compression in the second half of last year, office, hotel and retail cap rates remained either flat or increased, according to CBRE’s North America Cap Rate Survey.

Commercial real estate, building, brick, offices, retail, apartments, office real estate

“U.S. cap rates were largely flat outside of the retail sector in H2 2017, though a shift from sale to refinance activity contributed to lower transaction volumes,” CBRE Head of Americas Research Spencer Levy said in a report. “The recent spike in inflation and anticipated higher interest rates this year will add upward pressure on cap rates, offsetting the downward forces of expected strong institutional and global capital flows.”

Wage gains have spurred inflation increases — though still below the Federal Reserve’s 2% goal — which could trickle into cap rates.

A cap rate is the ratio between an asset’s net operating income and its value. Investors eye this figure closely when determining whether to buy or sell an asset because it allows them to quickly assess how much they are willing to pay in exchange for the rental income a building provides. A lower cap rate is favorable for sellers but typically means lower returns for buyers. 

Below is an assessment of H2 2017 cap rate movement and predictions for this year’s performance, according to CBRE. 

Office

For stable office assets within central business districts around the country, cap rates fell by 3 basis points to 6.65% at the end of last year compared to H1 2017. On the other hand, cap rates for suburban offices increased 4 basis points to 7.88%. Assets in Dallas-Fort Worth, Denver, Kansas City, Oakland, Oklahoma City, Philadelphia, Portland and Sacramento experienced drops in cap rates across multiple asset classes. According to CBRE, surveyed respondents largely expect cap rate movement for office assets to remain flat in H1 2018, though some anticipate an increase of at least 25 basis points during the six-month period. 

Multifamily

Commercial real estate, New York City, apartments, apartment building
Apartment buildings in Williamsburg, Brooklyn

On average, cap rates for infill multifamily properties fell 3 basis points to 5.23%, though there were pronounced differences in cap rate movement depending on class and market tier. For Class-A infill assets, cap rates in San Francisco and San Jose were the lowest in the country, 4%. Cap rates closed the year at 4.25% for Class-B asset acquisitions in those two markets. As for suburban multifamily assets, cap rates fell 7 basis points to 5.59% in H2 2017. Surveyed respondents overwhelmingly expect cap rates for both infill and suburban multifamily assets to remain as is in H1 2018.

Industrial

Cap rates for industrial assets, the red-hot darling of commercial real estate, fell in the second half of 2017 to 6.52%. Industrial markets with the lowest cap rates were concentrated on the West Coast in Seattle, Oakland, San Jose, San Francisco, Los Angeles and Orange County, CBRE reports. Surveyed respondents foresee cap rates remaining relatively flat in the first half of 2018, though 15% of respondents expect rates to decline 1 to 24 basis points.

Retail

New York City, New York skyline, towers, offices, office market

In the retail sector, cap rates varied for neighborhood centers compared to power centers and high street shops. Cap rates for grocery-anchored neighborhood centers rose 7 basis points to 7.33% in H2 2017, and almost 50% of those surveyed expect rates to remain the same in H1 2018. Power center cap rates jumped 44 basis points to 7.98%, though investors believe that segment of retail will improve in early 2018, potentially driving cap rates down again. High street retail centers — the lowest retail cap rates CBRE tracks — increased moderately to 4.67% at the end of 2017.

Hotel

CBRE reports that cap rates for most hotels in central business districts — including luxury, full-service and select-service assets — fell slightly to 7.98% in H2 2017, compared to suburban hotels’ 8.53% cap rate. Hotel assets are somewhat of a different animal compared to other sectors, since cap rates in the sector differ based on individual markets’ anticipated income growth. Cap rates for luxury assets in major CBDs like Boston, New York City and Washington, D.C., sat at 6%, while average cap rates for full-service hotels were 7.69%. As for 2018 outlook, those surveyed expect hotel cap rates to increase because of bumps in the 10-Year Treasury.