Report: Private Market Lags Public REITs in CRE Cap Rate Metrics

The report also showed significant valuation gaps in how the public and private markets view the office, hotel and life sciences sectors.

CenterSquare Investment Management, a Philadelphia-based real estate investment firm, examined implied cap rate metrics for roughly 200 publicly listed U.S. REIT companies. The firm then used private real estate data from the NFI-ODCE — an index of the largest private real estate funds — and estimates from analysts and brokers. Both data sets use second-quarter 2023 metrics. 

CenterSquare estimated that the valuation gap between all public REITs and private market values rose from 28 basis points to 50 basis points between the first quarter of 2023 and the second quarter, with the public REITs cap rate rising to 5.96 percent and the forward-marked private markets cap rate hitting 5.46 percent in the second quarter — a valuation gap of 8.3 percent. 

“In the ideal world, where markets are completely rational, the public market valuations would reflect what we are seeing in that forward-marked private market cap rate,” Uma Moriarity, senior investment strategist at CenterSquare, told Commercial Observer. “But there’s a really meaningful disconnect between where transactions are happening and where valuations are happening in the private market … compared to where we think private market valuations should be.” 

Cap rates are among the most critical metrics for measuring commercial real estate. They can generally be defined as the yields on real estate investments and are found by dividing net operating income by asset value. Cap rates typically rise and fall in concert with interest rates; lower cap rates suggest lower interest rates, cheaper leverage, higher prices for property and thus greater values, while higher cap rates suggest the inverse: high risk, low prices and low values on those assets. 

For most CRE underwriting to make sense, a building’s cap rate should be higher than the annual debt cost, otherwise cash flow will move toward paying off the debt rather than providing the sponsor with an annual profit. The rise in interest rates over the past 15 months has produced cap rate expansion, Moriarity said. 

CenterSquare’s research report found that public REITs cap rates for offices — the industry’s most distressed sector — have reached 8.75 percent, compared to a forward-marked private markets cap rate of 6.39 percent, reflecting a public-private valuation gap of 27 percent. 

Moriarity said that public market sentiment toward office is “overly bearish.” Meanwhile, private market valuations have lagged behind where they should be because private firms are using “trailing numbers” from private appraisers who haven’t accounted for updated balance sheets.  

“The gap between where appraisers are marking private market valuations, there’s an even bigger gap because those [assets] have not been appropriately marked to market for today’s debt costs and don’t reflect the implications of an economic slowdown from a growth perspective,” she said. “There’s such a big disconnect between where we think reality should sit versus where the private market actually is sitting, and the REIT markets have significantly overcorrected on the other side.” 

Other asset classes that are showing similarly large public-private valuation gaps in cap rates are hotels (18.2 percent) and life sciences (27 percent), according to CenterSquare data.  

Cap rates on hotels have likely expanded due to the asset class’ unique cash-flow model, which relies on leases that are more or less daily agreements between management and consumers, many of whom are impacted by wider macroeconomic patterns like pullbacks in consumer spending and fluctuating unemployment levels. 

“You don’t have that safety with hotels,” Moriarity said. “So hotels will always be a very high beta play within the REIT market and are currently reflecting the impact of an upcoming recession.” 

Life sciences cap rates have likely expanded due to the overbuilding, muted leasing demand and the asset class being lumped into the office sector, which has experienced similar headwinds. Some investors have erroneously equated low cellphone usage at life sciences centers to low office utilization numbers, according to Moriarity. 

“From a fundamental perspective, the long-term growth prospects for life sciences is miles apart from where traditional office might be, but it’s getting pulled into this sentiment of being an office-lite property type,” she explained. “But in a life science facility, what you’re fundamentally doing is conducting research and that research doesn’t necessarily require a person to be there 24/7, but it does require a tenant to be there to do the science.”  

On the flip side, the single-family rental and data center sectors saw cap rate compression in the last quarter (a basis point decrease of 29 and 10 basis points, respectively, over three months), according to Center Square.  

Single-family rental rents have been buoyed by a structural undersupply of U.S. housing and an increasing demand from millenials for new housing, while data centers have experienced strong demand stemming from corporate cloud providers investing in data center operations and the growth in computing power required by artificial intelligence, according to CenterSquare. 

Brian Pascus can be reached at bpascus@commercialobserver.com