Perhaps the most notable trend observed in the investment sales market in the first quarter of 2012 has been surprisingly shrinking capitalization rates on all types of investment properties. There are several reasons why this has occurred.
In late 2010, lending rates for commercial properties had fallen into the 5 percent range and several of our clients decided to refinance properties and lock in these low rates for as long as they possibly could. Who could blame them? After all, we have been in a low-interest-rate environment for so long that we forget that, over the past 25 years, the average commercial mortgage rate has been 7.9 percent. A rate of 5 percent, locked in on a fixed basis, seemed like a smart move. Remarkably, rates continued to fall through 2011 and, during 1Q12, several lenders announced five-year fixed products at rates around 4 percent and a few, who are very active, are lending at 3.5 percent or less.
Fixed-rate loans at these rates are highly attractive. However, if you are willing to float, rates fall into a tantalizing range below 3 percent. If you believe that rates are going to stay low for a long period of time (a risky bet), this strategy might work well.
With rates this low, investors have been lowering their yield expectations, which has exerted downward pressure on cap rates and, consequently, upward pressure on property prices. In fact, we have seen, within the past eight weeks alone, a drop of 75 to 100 basis points in cap rates across the city. Most notably, we have seen this trend in the multifamily market. However, cap rates have been compressing in the retail, office and hotel sectors as well. This trend is tangible and there are dozens of examples of properties on the market today that attracted offers only at a certain level months ago but now are attracting offers that are much higher or are under contract for sale at much higher prices than could have been obtained previously.
History has shown us that commercial lending rates and cap rates are highly correlated; however, while historically low lending rates are the main driver of this recent cap rate compression trend, they are by no means solely responsible for this dynamic.