Cap rates hit historic lows in the third quarter—falling 40 basis points (bps) to 5.9 percent, according to New York-based Real Capital Analytics (RCA). The previous low over the past decade was 6.1 percent, which occurred in the fourth quarter of 2012.
The cap rate for mid- and high-rise properties in major metros fell to 3.6 percent, which was almost 20 bps below the rates seen during the condo conversion craze of the mid 2000’s. Garden property cap rates fell 40 bps to 6.1 percent. Overall, mid- and high-rise properties fell 25 bps to 5 percent.
Not surprisingly, the decline in cap rates was the result of larger economic forces.
“A 25 basis points dip in mortgage rates and the weight of capital were primarily responsible for the cap rate compression,” RCA said in the report.
These low cap rates have raised the fear of a bubble, but RCA thinks this cap rate climate differs from the one that industry faced in 2007.
“The spreads between rates and treasuries are still pretty wide and the outlook for NOI is pretty good right now,” says Ben Thypin, director of market analysis at RCA. “I think the market would prefer that base rates increase sooner rather than later so we can absorb it over time instead of in a few years from now when pricing is higher and the outlook for NOI growth is less certain.”
Furthermore, RCA adds that lenders are getting a healthy risk premium in the current market with long-term fixed rate mortgages 160 bps above the risk-free rate, which was basically the same spread in 2007.
“These healthy debt spreads have not been accompanied by undue risk taking; valuation metrics for recent originations remain in line with the market and LTVs [loan to values] have increased minimally over the past year,” the report said.
The fact that investors and lenders haven’t lost their discipline is a good sign, but historic low interest rates could present risk.
“The wide spreads investors and lenders currently enjoy indicate they are not ignoring risk and, by historic measures, are being well compensated for it—factors uncharacteristic of a bubble,” RCA said in the report. “However, ultra-low interest rates caused in part by central bank intervention are an unprecedented risk facing investors.”