Real estate is priced on metrics relative to the level of risk. As is true in any market, investments with a higher perceived risk produce higher returns than investments that are perceived to be safer. Real estate has multiple components on which risk is judged. Some of those risks include:
Position in the Capital Stack
- A position within the stack is called a “tranche.” Tranches that get paid first naturally have less risk, and therefore the coupon increases as investors move up the capital stack. Senior debt mortgages have first claim to cash flow produced by a property, followed by mezzanine debt, preferred equity and equity.
Consequently, senior mortgages have the lowest returns and so on. In today’s market, senior loans have coupons of 4-5%, while mezzanine loans typically yield 6-10% and preferred equity 11-16%. Pref equity tranches usually have a portion of their coupon current-pay and a portion accrued for payment at maturity when there is a liquidity event such as a debt refinancing or a sale of the collateral property.
- Some property types are inherently less risky. Markets price the difference based on a combination of current trends and historical performance. Of the major property types, apartments (also referred to as “multi-family”) are viewed as the most stable. One reason is that people need to live somewhere whatever their personal finances or the state of the economy. Also, apartment vacancy rates have historically been the most stable among property types. On the other hand, hotels, which in effect renew leases nightly, are the most risky.
The risk-return for property types is reflected in acquisition yields, otherwise known as capitalization rates, which is the first-year return a buyer expects when it buys a property. Investors accept lower returns for properties that are perceived to be safer. The average commercial “cap rate” at the beginning of 2015 was roughly 6.5%, but there was a big difference depending on property type.
- Apartment cap rates were about 6%, office and retail about 6.8%, industrial about 7% and hotels about 8% on average nationally. Between the peak of the last cycle in 2007 and May 2015, values of apartments (27.6%), offices (9.7%) and industrial properties (0.7%) were up, while retail (-7.8%) was down, according to the Moody’s/RCA Commercial Property Price Index (table below).
Markets are generally segmented into primary (major cities), secondary (intermediate-size cities) and tertiary (minor cities). Cap rates are tighter (i.e., lower numerically) in “core” markets, or central business districts (CBDs) of major gateway cities such as New York, San Francisco, Washington DC, Chicago and Los Angeles, which reflects investors’ acceptance of lower yields for larger markets. More investors want to own in those markets because they feel confident that properties will perform up to expectations and that they will have an easier time selling if they so choose.
- According to the CPPI, downtown offices in major cities are 35.0% above their value at the 2007 peak, while suburban offices remain far below (-17.1) peak value.
- The bar chart below shows commercial real estate (CRE) values in Major Markets outperformed CRE values in Non-Major Markets from investments made in November 2007 and in January 2010.
A key component of prudent investing is to identify metros and submarkets within metros that are relatively under-priced compared to major markets that have more competition for buyers. In today’s market, big coastal cities are teeming with investors that are buying properties at historically low returns. Meanwhile, investors can obtain higher returns in less trendy markets such as the Midwest, where there is competition from fewer investors, often with a minimal increase in the level of risk.
Well-capitalized sponsors can borrow at lower coupons than ones that have less financial wherewithal or are less-established. As with geography and property type, investors can boost returns by identifying good borrowers who might not have the track record of more established peers.
The upshot is that there are many elements that go into commercial real estate returns that are based on long-standing measures of risk and historical performance. Experienced real estate investors that know how to navigate through these waters can identify smart investments that produce above-market returns and outperform the market.