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Capital, both equity and debt, is the lifeblood of the investment real estate industry. The availability and cost of that capital has a direct impact on the vibrancy of commercial real estate markets and values of properties. The relationship between the cost of capital — better known as interest rates — and the rental income rate from a property, known as a property’s capitalization rate (CAP rate) is one of the indicators investors use to determine how attractive a return might be for an investment in a particular investment property. For those not familiar with the terminology, a CAP rate is the net operating income (NOI), or initial return, of an investment real estate property divided by the price of the property. If you’re talking about fixed-income bonds, the CAP rate would essentially be the bond’s interest rate. Because income from real estate investments typically increases over time, the CAP rate is not only the initial return but is also a rough projection on future returns.
The CAP rate an investor is willing to pay for an investment property is related to the investor’s view of what the building will likely produce in future cash flow and the probability of receiving that cash flow, otherwise known as the risk factor. The higher the investor’s expectation of future net operating income (NOI), the net cash flow received by the investor and their confidence in the certainty of actually receiving that cash flow, the lower the CAP rate the investor will pay for the investment. The lower the investor’s expectation of future NOI and the higher the risk of receiving the future cash flow, the higher the CAP rate the investor will demand at purchase. During the first half of 2022, the average CAP rate across the country for all types of commercial real estate investments was in the 250 to 300 basis points higher than the 10-year treasury yield, compared to a 290-basis-point average from 2013-2018. With current 10-year Treasury bill yields around 2.8%, the national CAP rate average would be in the 5.3% to 5.8% range.
As the Aspen commercial real estate market emerges from two years of the COVID pandemic and record influx of tourists, new home buyers, new restaurants and international retailers, we’ve seen substantial increases in commercial rents. In the past decade since the Great Recession, commercial rents have increased on average 7% to 12% per year, depending upon a property’s location, with a large part of that increase coming in the past two years. In comparison, over the past four decades, Aspen commercial rents have grown on average about 7.5% annually. The primary reason for this strong rent growth has been a very restrictive supply due to zoning pressures combined with long-term demand from businesses wanting to locate in Aspen — leading to extremely low vacancy rates compared to other more typical markets around the country.
With this backdrop, one of the primary questions on the minds of owners, investors and appraisers is, what is a CAP rate for Aspen commercial real estate in today’s investment market? The best method to answer that question is to do a discounted cash-flow analysis where a variety of factors are considered including available financing, projected rent appreciation, whether the subject property has existing rents below, above or at market rents, potential risk factors such as tenant defaults or vacancy, and what investors feel is a reasonable return on invested equity. A good starting point to determine a reasonable return on equity invested in real estate would be the stock market. Over the past 90 years, the S&P 500 has produced an estimated compound average return of 10.5% per year.
Using reasonable assumptions in today’s market for vacancy and credit losses, the historic long-term average appreciation in Aspen commercial rents of about 7.5%, and a reasonable projected annual return on invested equity of about 10% to 11%, you can run a discounted cash-flow analysis model to obtain a ballpark CAP rate. The financing used in this model is a 50% loan to purchase price with a 1.25 debt coverage ratio amortized over 25 years at a 5.4% interest rate which is reasonable financing in today’s market.
The result produces a CAP rate of around 4.5% for an average downtown Aspen Âcommercial Âproperty, which is about 100 basis points (i.e. 1.0%) below what the best investment real estate might sell for in other parts of the country. CAP rates are used in the investment real estate industry as a back of the envelope approach to reach a ballpark starting point to valuing commercial property so this benchmark CAP rate could vary depending upon a number of factors including interest rates on financing. With mortgage interest rates trending up over the past year, CAP rates have been trending up as well.
Ultimately, what an investment property might sell for depends a great extent on what the needs are of the investor and unique characteristics of the property that could make it more or less valuable. The CAP rate approach to valuation is merely a starting point.
Lori and William Small, CCIM are recognized luxury and commercial real estate experts with Coldwell Banker Mason Morse in Aspen. They can be found through their website theSmallsaspen.com or by email at th*******@th************.com.
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