Is our focus on commercial real estate cap rates too simplistic?

strip-mall Capitalization rates and mortgage interest rates are considered among the most underlying driving force of commercial real estate sale activity. However, our chatter when discussing Saskatchewan Commercial Real Estate values can tend to focus primarily on Capitalization Rates. As those cap rates continue to compress, it is important to consider the bigger picture.

Obviously we have to be careful when generalizing about cap rates and commercial mortgage lending rates because they can vary significantly depending upon the asset class, condition of the property, price range, depth of the borrower, etc.

The good old days

We often talk about the old days when cap rates were 12%. At the same time five year term, commercial mortgage lending rates averaged 10% which offered a spread of 2%. When I compare those days gone by to current times there is an interesting parallel. Again, I need to speak in generalities…however we see a similar spread today. Taking into consideration the above mentioned factors we could say that present Saskatchewan Commercial Real Estate cap rates are averaging 6.5% with mortgage rates in that 4.5% range. There we are….that 2% spread.

My purpose in discussing this is not to encourage more Buyers to consider investing in commercial real estate. We certainly have more demand than supply right now and there doesn’t appear to be any change likely in the near future.

Even though the current spread is similar to the old days, the risk may be greater today. It is dependent upon that age old question of where interest rates may be several years from now.

Where are we going?

Let’s say I invest today and secure a mortgage with a five year term. Let’s also assume commercial rates have increased 1.5% in five years when I go to renew; my spread is now 0.5%. It’s possible that the assets’ income capacity may now not meet the loan servicing requirements and there is a “cash call” requirement.
Buyers were also vulnerable in the above example of 12% cap rates and 10% mortgage rates. We sold real estate in 1981 when five year rates exceeded 20%…who’s to know?

Is the moral of the story, it’s time to sell? You can ask ten different economists that question and you’re likely to get ten different answers!

Past 55 and Forgetful

If I’m investing in the commercial real estate market at today’s cap rates I would have two goals. Secure a fixed mortgage rate with as long a term as possible and invest my surplus cash flow back into mortgage principal reduction. My belief is this is going to provide the best protection against future interest rate increases. After selling real estate in the early 80’s at a time we experienced 20%+ mortgage rates, I vowed never to provide advice in this area…so why now?
Do I think I’m smarter? No….just past 55 and forgetful !!!

Posted by Barry Stuart


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