Net Lease Cap Rates on the rise?

Market drivers continue to be restricted access to credit, decreased transaction velocity, growing product supply and a diminished buyer pool. As these fundamentals result in a contraction of values for all investment property types, cap rates for net leased retail, office, industrial and medical deals have all registered increases of 150 to 200 bps since establishing market lows in the first half of 2007.

In the first quarter of this year we projected cap rates would continue to rise another 40 to 50 bps by the end of the second quarter. Through our opinion poll, 35% of all voters agreed and projected a rise over 40 bps. This aligns with rise of 40 to 50 bps over the last 90 days that we’ve encountered

Because of the typical 90-day lag between deal origination and closing, newly executed LOIs serve as the best leading indicator of cap rate movement today. Newly-executed LOIs are an especially important forecasting tool in the current market due to the speed at which cap rates are adjusting. Over the past quarter we have seen rates on newly executed LOIs increase an additional 20-40 basis points compared to closing cap rates occurring in the same quarter.

So where do you see cap rates going from here? What is your opinion on how much cap rates will change between July 1, 2009 and September 30, 2009?

Well since caps are based on the NOI and the value of the property it really depends on what the owner can do with the property to effect that.

Me personally I don’t put too much emphasis on caps like most commercial investors do to me other factors affect my decision on whether or not I will purchase a commercial property.

I think your question is necessarily too narrow. Asking what will happen to cap rates over a 90 day period (and I know you really refer to single tenant NNN properties) is not much different than asking what will happen to cap rates in southwest Sheboygan Wisconsin next Thursday – no one knows and the answer is largely irrelevant. Broadly speaking however, over at least the next few years, I think cap rates will continue their way up. The rate will differ as a function of deal size, in my opinion.

Credit is still reasonably available for smaller properties (<$5m) and there is a tremendous amount of cash waiting for the right opportunity. However, the gap between buyer and seller expectations has widened to the point where only distressed deals are closing. Cashflowing, unmotivated owners are just not putting their properties on the market. Thus, product supply is shrinking but not as fast as it could. The lower grade distressed deals inherently have higher caps, comprise the majority of the market, and are driving prevailing cap rates up. This will continue until cap rates rise to the point buyers get tired of sitting on their cash (e.g. treasury rates are unappealing low). Until then, cap rates on smaller properties are still too low and prices have a way to plummet.

The larger, institutional grade deals, have a much bigger problem. Here, credit has tightened to the point that refinancing is a problem. Perfectly performing, cashflowing, well positioned assets, face the possibility that as their typical 3 to 7 year paper comes due, there might not be a way to requalify. The problem gets worse as LTV’s drop due to credit tightening and NOI’s drop due to our economic situation. In fact, Deutsche Bank reported recently that for 2007 vintage loans, maturing in 2009 – 2012, the percent of institutional grade retail and multifamily properties that would not requaify is 90.9% and 81.4%, respectively (I had to read that a few times myself). Cap rates could skyrocket beyond their historic 9% to 10% pre 2000 averages. Depending upon the side you are on, this could be a disaster for larger investors or the opportunity of a lifetime. Either way, cap rates have nowhere to go but up.