Income property value is based upon a net operating income (NOI) rate of return. That is, if owned free and clear what would be the annual rate of return based upon that net cash bottom line without interest, depreciation or capital expenditures. This rate of return is called a capitalization (cap) rate. A NOI of $90,000 at an 8% cap = $1,125,000. Or a property listed at $3million with a NOI of $270,000 is an offering at 9% capitalization or rate of return.
We have recently come off of the lowest real estate capitalization rates in history. The investors always prefer the “safe rate” over a riskier investment so there is a direct correlation between “safe rate” and real estate cap rates. Two years ago prime rate set by the Feds was near zero and hence safe rates like insured bank savings, Certificates of deposit (CID), treasury bills (T-bills) and AAA rated bonds were very low in the one half percent to 2% area. Real Estate cap rates fell to 5% or even lower on a triple A rated long term absolute net tenant.
In the past year and a half safe rates have doubled and doubled again. We just put some cash into a FDIC insured CiD at 5%. Two year T-bills were going at 7% this morning. If these are “safe rates” with little to no risk, real estate investments have climbed the latter simultaneously. When I used to buy and sell apartment buildings a safe rate was around 5% and the real estate multi-family market rate was around 10%. Certainly size, condition, location, potential, tax consequences all enter into the equation of negotiating a sales price.
In real estate we brokers are at the grass roots or cutting edge of value changes. We like to say that the bankers are always a year behind the real trends. Well at this point the investment real estate brokers are mostly a year behind the safe rate vs market rate needed to sell income properties. There will be a substantial “spread” to justify investors taking the risks that come with real estate over sure thing investments. Each investor determines their safe rate as to what liquidity and guarantees are available to make that a very low to no risk. Then there needs to be enough incentive to forego the safe money and risk it on an income property. If the prime rate falls, cap rates will fall and if the prime rate continues to rise, the cap rates will rise with it. Sellers and brokers will need to adjust to that fastest rise in rates in history.
If safe rates went from 1% to 5%, then income property is likely at 7.5% to 10% with a great variance depending on the income property’s risk.
Tom Goebel
April 20, 2023
