I noticed it is easy to find commercial properties in Houston/Dallas/Austin that have cap rates in the 10-15% range, while in NYC it's pretty hard to find anything with a cap rate above 5%. From what I understand about cap rates, they are lower in cities that are expected to have more future appreciation.
So, why are cap rates so high in Texas? I would think massive oil and natural gas reserves plus a surging population would equal bullish market for Texas real estate over the next 25
years. Why is commercial real estate being priced for a zero growth environment?
Texas Cap Rate Compared to NYC
Cap rates can be looked at as a reflection of risk. Texas is a great market, however, NYC is one of the safest places to invest in real estate, in the world. Cap rates reflect this. The more capital that wants in a place, NYC in this case, the more compressed the cap rates. NYC also has greater barriers to entry and Texas is far easier to develop in.
Look at average cap rates nationwide.
User NYCbander goes into detail:
What Determines Cap Rates
- As far as cap rates on CRE in general in Houston/Dallas/Austin vs. NYC, you're talking about a pretty big universe. Five percent seems pretty tight for the NYC metro as a whole, that might just be a Manhattan number. Like, your Texas data point is a huge metro area which includes big swathes of undeveloped/suburban land, whereas I would guess your NYC data point is just Manhattan. You need to look at the type of assets involved.
Within office, we divide between "CBD" and "Suburban Office." CBD is like, your sexy ass skyscraper downtown somewhere, and "suburban office" is like, that shitty little office park off the highway that your dentist is in.
Nobody wants to put long fixed rate paper on hotels that rely on F&B for a significant portion of their revenue, because those places end up being cool for a couple years and then people stop going there. For example, just to make the math easy let's say at T=0 I put a $15mm ten year mortgage on a hotel with $1mm NOI, 50% F&B revenue, and a 5% cap rate, so that would be like a $20mm value and a 75% LTV.
Let's say the place was popular until t=5, when F&B revenue falls to zero. Assuming no change in cape rate, ive now only got $500,000 NOI because my 50% F&B is gone, so capping at 5% the building is worth $10mm, and assuming my loan was IO (just because I really dont want to calculate mortgage style am in my head right now) ive got $15mm on a $10mm builing. I would be, as the British say, "proper fucked." my 75% LTV loan just became a 150% LTV loan. Those are just rough made up numbers, but you see the risk right? This type of property is more of an operating asset and is generally financed as a short term floater. 3+1+1 is basically market.
If you put an example of each asset type street next to each other, assuming equal quality, the order of cap rate on each one from tightest to widest would go: multifamily, CBD office, Mall, Power/Lifestyle Center, standalone retail, suburban office, full service hotel, limited service hotel, full service hotel with large F&B. at least in my opinion and its somewhat dependent on geography. That's more of a "base case" type thing.
The point is that there is no one single cap rate in any market.
- With respect to your cap rates/appreciation point, I hate to be the bearer of bad news, but by definition, it can't be true that there are lower cap rates in markets where more appreciation is expected. Appreciation is a function of cap rates, not the other way around. Cap rate would be the independent variable, and property value/appreciation would be the dependent. Cap rate is a valuation metric, so you can't really say that a given baseline market cap rate implies a certain level of appreciation, because by the time we're able to calculate a cap rate the expected appreciation has already been priced in.
How I think of cap rates is as the discount rate on perpetuity.
The perpetuity is the property throwing off cash flows, and the cap rate is how you value/discount the cash flows that property is throwing off. Look - CRE doesn't have any intrinsic value beyond its ability to produce rents / a stream of cash flows. Think of it as a special type of bond that happens to have a street address instead of a CUSIP. If you take two properties with an identical NOI but different cap rates, it implies that the cash flows of the property with the tighter cap are somehow "more valuable" than those from the property with the wider cap. What could possibly be driving that difference? It's a risk premium dude.
All that a cap rate does is value a building as perpetuity based on current NOI. A tighter cap implies that the markets believe you are relatively more likely to be able to sustain your NOI in perpetuity.
Why Is The Cap Rate In Texas High Compared To NYC?
- Can't precisely tell you why your Texas cap rate number is so high relative to New York. Five percent across all asset classes in the greater NYC metro just strikes me as unbelievably tight, so that should account for some of it.
Keep in mind what we call "infill" location. The tightest caps in the country are in Manhattan, Boston, and San Francisco. What do all these cities have in common? Limited geographical space. Manhattan is an island and Boston and SF are peninsulas. There's only so much space you can build on and still be in any of those cities. There's just nowhere to physically put a new building. So that's called an "infill" location. Like, nobody can challenge them (landlords) by building because the block is already filled up. In Dallas/Austin/Houston where you've got miles and miles of space to expand this is more plausible.
How Does Growth Affect Cap Rates
- You're thinking about this correctly in that you're taking one market and trying to think through the effect it will have on other markets as it moves, but you have to keep in mind that magnitude matters when analyzing market moves,
Not every single asset with exposure in the area will experience growth. It should be repriced such that it's now as valuable as some of the most valuable assets of its type in the world (Like Manhattan real estate.) plus you have to keep in min the infi issue - if rents ever appreciate significantly in Dallas, people will just build new buildings. Can't do that in NYC.
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