Scarcity Premium Seen Driving Current Cap Rate Compression

With Little Quality Office Product in Play, Investors Vying Sharply for Low Hanging Fruit

By Mark Heschmeyer

Last year, capitalization rates on large office property sales rocketed from the mid-6 range to the mid-8 range. So far this year, cap rates have reversed course, falling back just as rapidly to mid-7 range. Under ‘normal’ conditions, this would imply that property values are increasing. So why isn’t the commercial real estate industry elated?

Cap rates are a benchmark determined by dividing income by property value. Increasing cap rates typically imply that property values are falling. Last year, no one in commercial real estate doubted that the rapid rise in cap rates reflected an equal rapid decline in property values.

[BLOGGER COMMENT: This is a bifurcated market. Class D&F assets are being sold at a dramatic discounts to replacement cost for cash since no financing is available for low quality assets. Class A&AA assets are receiving 20-30 bids when those assets come to market from investors that have raised trillions of equity capital and need to place it before their investors start asking for their money back. The trend toward low cap rates in investment grade assets will continue as the 10 year Treasury stays at such low levels (3.48% as of this writing) and positive leverage can be achieved.  I predict the return of transactions for Class B&C assets will only happen once CMBS 2.0 hits high gear in Q3 or Q4 of 2010.]