Industry Leaders: Cap rates, value and highest & best use will continue to be in transition by Rynne

The real estate market has been on the continuum of low overall capitalization rates (cap rates) driven primarily by the monetary policies of the Federal Reserve. It’s been a long time period, primarily since the financial meltdown in late 2008 and early 2009. Not only have the low interest rates been responsible for the most active real estate market since the mid 1980’s, low interest rates have also been driving the entire economy in all industries. A real estate example of this includes a recent sale in Manhattan of a high rise development site that sold in excess of $600 million per acre or in excess of $13,774 per s/f. Another sale which was a branch bank tied to a 20-year triple net lease at a 4% cap rate on Long Island.  A 2015 sale of a 9 year old apartment complex in the Boston area had a cap rate of 4.5%. Upstate New York and Western New England also has had some unprecedented real estate activity and sale prices. A new Rochester single tenant retail outlet sale secured by a good credit and 10-year lease had a cap rate of 6.30%. An Upstate New York older automotive facility sale with some history of contamination had a cap rate of 6.71%. A 2015 apartment sale in the Syracuse area had a cap rate of 6.1%.  An Albany area large apartment sale had a cap rate of just under 6% in late 2014.   Upstate New York and northern/central western New England have shown cap rates for class A office buildings with a statistical mode centering around 7.5%.  Class B office has a statistical mode centering around 8.75%. Regional and community size retail projects in the Upstate and northern/central western New England have cap rates centering around 7.75%. Light industrial has cap rates which center around 8.5%.  Upstate and northern/central western New England Suburban apartment project cap rates center around 7.25% and Urban apartment cap rates center around 7.75% . What has kept real estate values from escalating further is some increasing supply which put some lid on rentals.  These low interest rates have decreased the economic life of various properties because debt service is so low that highest and best use becomes more flexible. Thus, complete redevelopment of a property is more frequently feasible.   Physical depreciation is defined as the natural deterioration of short/long lived components of the site and building improvements. The old adage that more buildings are torn down than fall down is the “poster boy” for functional and external obsolescence. Functional obsolescence is the diminishment of value attributed to the inability of the improvements to conform to market standards. An example of this would be inefficient floor plans, inefficient heating/cooling, outmoded design, etc. External obsolescence is the diminishment of value due to factors outside the lot lines of the property. It could be a locational issue such as being adjacent to a contaminated property or an obnoxious smell/noise due to an unusual specific manufacturing complex.  However, the most common form of external obsolescence is that of economic. Economic obsolescence most of the time is related to supply/demand imbalance. If there is an oversupply of space, rental rates are reduced which could result in negative cash flow for the property. On the demand side there may be insufficient income levels for a certain use. As an example, a high-end jewelry store in a low income, high crime area where a mini-mart may be more homogenous. Redevelopment does spur economic growth through direct purchase of building materials, employment in regards to construction jobs and ancillary jobs such as architectural, engineering, legal, accounting, financial, appraisal, etc. Conversely, increasing interest rates increase effective age as a result of economic obsolescence. As an example a 75% loan/value, $20 million and 20-year amortized mortgage given an interest rate of 4.5% versus 7% results in a extremely high difference in annual debt service. The annual debt service for the 4.5% example is $1,518,359.  The annual debt service for 7% is $1,860,717. Thus, the difference is $342,358 in annual debt service.  This could translate to a value loss of $4,000,000 or 15% reduction in value when increasing the interest rate to 7%.   Remember, 7% was not that uncommon for a commercial mortgage until 10-12 years ago. In summary, low interest rates are continuing to drive the economy, especially real estate. However, these low interest rates will eventually move upward which will result in higher cap rates and lower values. The question is, when and how much? Overall rates are likely to remain relatively low for 2016.  Cap rates, value and highest & best use will continue to be in transition. John Rynne, MAI, SRA is the president and owner of Rynne, Murphy & Associates, Inc., Rochester, N.Y.