Commercial real estate investment returns come from two sources, rental income and price appreciation. To achieve large amounts of both, commercial property investors need to have a detailed understanding of what drives each higher.
In order to understand how the below drivers impact commercial real estate prices, it is first necessary to review how commercial properties are valued.
Commercial Real Estate Valuation Overview
Unlike residential properties, which are valued based on comparable sales, commercial properties are valued based on the amount of Net Operating Income (NOI) / cash flow that they produce.
Net Operating Income is calculated as a property’s rental income less its operating expenses. The more a property produces, the more valuable it is. Once calculated, it can be divided by a capitalization rate (cap rate) to estimate a property’s value. Cap rate in real estate is an estimate of the annual return that an investor would expect to earn should they purchase the property with all cash.
For example, suppose a property produces $100,000 in Net Operating Income and an investor estimates an 8% annual return. The estimated value of the property would be $1,250,000.
All of the driver’s of a property’s value impact one of the basic elements in the above equation – income, expenses, or cap rate.
Driver #1 – The Risk Free Rate
All investments contain risk, but the purchase of a 10-Year United States Treasury Bond is considered as safe as it gets. Repayment is backed by the full faith and credit of the United States Government and the interest rate paid is commonly referred to as the “risk free rate.” Cap rates paid for a commercial real estate investment are always relative to the risk free rate.
The basic concept behind this idea is that a commercial real estate asset is considered to be riskier than a 10-year Treasury Bond. As such, investors should be compensated for taking the additional risk. The exact amount of this compensation, the “risk premium,” depends upon each investor’s perception of the risk in a given deal. For example, one investor may review an office space deal in New York and require a 4% premium over the risk free rate, while another may require 5%. Assuming the risk free rate is 3%, this means that the first investor would be willing to pay a 7% cap rate for the property and the second investor would be willing to pay 8%. This results in a material difference in the sales price.
But, the risk free rate is not static. It changes over time. In fact, it has fallen steadily from ~15% in the 1980s to ~1.2% in 2021. If the risk premium stays the same, the cap rate that an investor is willing to pay for a property also goes down. A 3% risk premium in 1980 means that an investor would pay an 18% cap rate for a property. That same premium in 2021 means an investor would be willing to pay a 4.2% cap rate – a much higher price.
The point is this, the cap rate an investor is willing to pay for a property is partially influenced by the risk free rate. If it falls, investors may be willing to pay more for a property. If it rises, they may be willing to pay less. Everything is relative to the perceived risk in the asset.
Driver #2 – Jobs
The connection between jobs and the real estate sector may not be as direct, but at the root of every strong commercial real estate market is a strong job market. People follow jobs. Companies follow people.
But, not all jobs are created equal. Cities like Orlando and Las Vegas have historically strong job creation numbers, but the jobs tend to be relatively low paying and tied to the service industry which is notoriously cyclical. Other cities like Denver, San Francisco, and Nashville also have strong job creation numbers, but they tend to be of the higher paying variety in the technology, energy, financial services, and education industries, which tend to be more resilient during an economic downturn.
Strong job markets attract people seeking those same well-paying jobs. An influx of more people requires more businesses and services to support them. Additional businesses means additional space is needed across all CRE property types including office properties, industrial properties, retail shopping centers, self-storage, healthcare, and multifamily. The basic rules of supply and demand dictate rising prices in the strongest markets.
Driver #3 – Occupancy Rates
Occupancy rates are a simple function of supply and demand. If a property has a high vacancy rate (low occupancy rate) it likely means that there is some sort of issue that is preventing a tenant from leasing space in it. Perhaps the pricing is too high, perhaps the space lacks functionality for its intended use, or maybe the property owner is unwilling to negotiate favorable terms for the lease. In such cases, it is unlikely that new properties will be constructed in markets with high vacancy because the demand is not there.
Conversely, if a property has a low vacancy rate / high occupancy rate, there may be few alternatives for renters looking for additional square feet. In such cases, investors may be willing to pay higher prices to acquire a property that is already full. Or, investors may recognize the need for additional space to be constructed and start the development process.
The bottom line is that markets and properties with high vacancy rates are unlikely to rise in price until they are full of rent paying tenants. Markets with low vacancy rates have a better chance of rising prices due to the existing demand for space.
Summary & Conclusion
When investors and property owners have a good handle on the metrics that are driving prices in a given market, they have a more realistic picture of the potential risk/return profile of their investment opportunity.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
