Texas Cap Rates

Hooked on LEAPS's picture
Rank: King Kong | 1,178

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

  1. 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.

  2. 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.

  3. Why Is The Cap Rate In Texas High Compared To NYC?

  4. 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.

  5. How Does Growth Affect Cap Rates

  6. 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.

Read More About The Technical Side Of Real Estate On WSO

Decided to Pursue a Wall Street Career? Learn How to Network like a Master.

Inside the WSO Finance networking guide, you'll get a comprehensive, all-inclusive roadmap for maximizing your networking efforts (and minimizing embarrassing blunders). This info-rich book is packed with 71 pages of detailed strategies to help you get the most of your networking, including cold emailing templates, questions to ask in interviews, and action steps for success in navigating the Wall Street networking process.

Networking Guide

Comments (15)

Jul 27, 2013

Think about cap rates as more of a reflection of risk. Texas is a great market, but NYC is one of the safest places you can put money to work in real estate and cap rates reflect that. Tons of capital wants in to NYC and that compresses cap rates. Also, NYC has higher barriers to entry than Texas (its easier to develop in Texas). So generally thats why NYC cap rates are lower. Even so, a trophy office building in Houston is going to trade at a pretty darn low cap rate compared to some random strip center in Austin.

Best Response
Jul 27, 2013

Ha, well of you really are "newb" at least you're asking the right questions, so you're thinking about it correctly.

You make a lot of points here that I'll just comment on in chronological order.

1. As far as cap rates on CRE in general in Houston/Dallas/Austin vs. NYC, you're talking about a pretty big universe. You have to be careful that you are comparing apples to apples. 5% 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. Like... There's not a snowball's chance in hell that a shitty strip mall in Gravesend or whatever trades at a 5% cap. Plus you have to take asset class into account, because each one implies a different cap rate. Like, comparing the cap rate on a hotel in New York to a mall in Houston doesn't really tell you much, they're fundamentally different assets.

The major high level CRE assert classes are multifamily (like, apt. Buildings), office, retail, and hospitality (hotels.) within these there are lots of sub-groups, but the ones it's important to know about are:

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. Btw - this, and all the following stuff in the rest of my comment, isn't meant to be a comprehensive overview that hits every asset class. Just painting broad strokes here, going for the major ones. Like I ignored medical office for example because fuck it.)

Within hospitality we broadly divide between "limited service" and "full service." Limited service is like your shitty days in motel type thing off I-95. Full service is like your fancier hotel that's more of a destination in and of itself. And then within full service you need to further distinguish between hotels with a significant "F&B" (food and beverage) revenue component and those without. Hotels with significant F&B revenue are like, your fancy club hotel things and they get underwritten pretty differently from everything else.

The thing with those properties is that commercial mortgages tend to be decently long (5,7,10 are pretty normal for a fixed rate CML) with a significant balloon payment at maturity (the most common maturity/am schedule overall in this space is probably a 10 year maturity with a 30 year amortization schedule. So like, 10 years from now you've got a big slug of principal balance that needs to get refinanced or you're going to end up the proud new owner of a hooters in Tallahassee or something. I hear the wings are delicious.

Anyways, I digress. 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. Lets 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. A good example of how these abnormal credits get underwritten if you'd like to learn more is the standard hotel in Meatpacking. It was securitized in one of the 2011 private label CMBS floaters, if memory serves it was DB's, so COMM 2011-FL1, but I think JP did a similar deal probably called JPMCC 2011-FL1 or something and it might be in there. Anyways, I forget who rated it but if you make a free login on the Fitch or Moody's websites you should be able to pull a presale report which will lay out the underwriting in detail since the standard is going to be one of the top loans in the pool. Actually now that I think about it I'm pretty sure I remember that S&P rated the JP floater, because it was the first deal the street let them rate after they fucked up Goldman's deal (GSMS 2011-C3 I think?) over the summer by pulling their rating between pricing and closing. Those are probably rated by two agencies though and S&P sucks at CMBS so check Moody's/Fitch.

But just to drill back down on the task at hand, retail is probably the most nuanced RE asset class in terms of sub-categories, but the big ones are "malls," "power/lifestyle centers" (like... Strip malls and giant strip malls basically) and "standalone" (just some store on the street or whatever.)

So, to explain the reasoning for taking you on this long, rambling journey through the wonderful world of weal estate, to go back to the apples to apples point I tried to make what seems like a lifetime ago, each of these asset classes implies a different cap rate relative to each other. Like... If you put an example of each asset type I named on a 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. Different CRE asset classes imply relatively wider or tighter cap rates, so if a given market's CRE inventory is overweighted towards a given asset class, your "total market cap" number is fucked. Anyways, it's pretty much meaningless to compare markets as broadly as that. We should be comparing like to like and then analyzing the spread.

2. 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. This is because 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. Does that make sense? 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 a 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 like 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 a 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.

3. Can't precisely tell you why your Texas cap rate number is so high relative to New York, but frankly I suspect that you're not comparing apples to apples. 5% across all asset classes in the greater NYC metro just strikes me as unbelievably tight, so that should account for some of it.

Another element that you have to keep in min is 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. Even if someone sees a landlord in Manhattan or something making an absolute killing, enough that it would make sense to build a new building, there's just nowhere to put it, physically. So that's called an "infill" location. Like, nobody can challenge them by building there because the block is already filled up. In Dallas/Austin/Houston where you've got miles and miles of space to expand, if rents ever get nutty on offices or whatever, someone will just throw up a new building. It's econ 101 - increased supply with stable demand lowers the clearing price, so the property's ability to produce cash. Is dinged, an the value of the property falls. Remember, CRE is only worth as much as the discounted value of the cash it generates.

4. With respect to your energy/nat gas/long Texas point - look, I think 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,

Like... I agree with your energy story, plenty of people will be making plenty of money in Texas in the medium/long term. But do I believe that the Texas energy rally will be of such biblical proportions that it will rewrite the current paradigm to the extent that an office building in Austin is as valuable as an office building in Manhattan? No, I don't believe that. Not in this lifetime at least.

Just because you can tell a believable growth story doesn't necessarily mean that every single asset with exposure the area you've convinced me there will be growth 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.

Anyways, feel free to PM me with any questions.

    • 4
Jul 28, 2013

http://www.cbre.com/AssetLibrary/Cap%20Rate%20Surv...

Pricing is not being placed at "zero growth", pricing is more aggressive than it has ever been and its been hard to get deals done with everyone dumping money in our market for low ass yields.

Dallas
Industrial: 5.9-6.8%
Urban Multifamily: 4.25-5.25%
Hotel: 7-8%
Office: 6.5-7.5%

Houston:
Industrial:5.8-6.75%
Suburban Multifamily: 5.25-6.5%
Urban Multi- 4.5-5%
Office CBD: 5.5-6%
Retail: 5.5-7%

The reason why they are lower in Texas than in NY is for many reasons, here's a few basic ones:

-NY is a high barrier to entry market which severely limits the competition and amount of new supply
-NY is vertical market where in Texas you don't have to renovate older structures- you just build on the empty lot next door
-Rental rate and equity appreciation occur at a much slower pace in the SW/SE than on the east/west coasts (it makes more sense to buy at a 4% cap when your yoy rent growth will be 6% compared to 2%)

Jul 28, 2013

Thanks for the very helpful answers. I was basing my numbers based on what I found on Loopnet. I guess the properties with 10-15% cap rates have something fundamentally wrong with them?

NYCBandar: I don't think Houston properties will ever be as expensive as Manhattan real estate, but I think with all the oil and natural gas money about to flow through that state, I'd expect at LEAST 5% annual appreciation over the next 10 years. I'm also expecting higher commodities prices as well.

I really wish I had $200,000 to put down on a $1 million property in Houston, but I'm about $180,000 short and don't have much credit history. Hopefully it will not be too late by the time I graduate, have a good credit history and a some what decent job. WSR and AMRE seem to be decent plays on Houston real estate, but I'd prefer a more pure play and I hate buying anything near a 52 week high.

Competition is a sin.

-John D. Rockefeller

Jul 29, 2013

"I was basing my numbers based on what I found on Loopnet."

Loopnet is not a good indicator of cap rates. I am sure the 10% cap properties are class C in not so great locations or have huge renovations that are needed. We advise developers and RE investors all the time and cap rates for Class A multifamily in nice parts of Houston are 5.25% - 5.75%.

Jul 29, 2013

Hooked, you're looking at cap rates in too narrow of a definition. Cap rates are just indicitive pricing of which many factors are built into, not just appreciation.

Jul 30, 2013
TeddyTheBear:

I am sure the 10% cap properties are class C in not so great locations or have huge renovations that are needed. We advise developers and RE investors all the time and cap rates for Class A multifamily in nice parts of Houston are 5.25% - 5.75%.

and I could very easily see class A multifamily cap rates lower than that in Houston, on occasion. Easily.

Jul 30, 2013

There are some transactions we advised against for a few clients. I have only seen a few go below the 5% mark too be honest. One was a trophy office building and the asking cap was 4.75%. We advised them against it and I am not sure what happened with it. I haven't seen multifamily go under 5% yet though and we have done transactions on class A projects right near the CBD. The appraisals for those areas have been coming in at 5.25% or so. Debt from large banks is about 200bps - 250bps + LIBOR and then perm financing with Fannie is typically a 10/25 structure at a 4%-5% rate. So the only reason it makes sense for investors to purchase these properties is if there will be strong rent increases going forward.

Aug 6, 2013

^Or if you invest on the West Coast

Aug 7, 2013

As you are doing in Texas we are trying to do same in our country so can you help us we are Best Real estate company Om construction and Builder in Bhopal Residential commercial industrial properties buying selling - Best Square feet - The Real Estate Promoter In Bhopal. Real estate Bhopal Ayodhya by pass Flats /Apartment Independent House , Plots , Land Property sale.we are builder in bhopal you can visit
.............................................
builder in bhopal

Aug 7, 2013
Hooked on LEAPS:

NYCBandar: I don't think Houston properties will ever be as expensive as Manhattan real estate, but I think with all the oil and natural gas money about to flow through that state, I'd expect at LEAST 5% annual appreciation over the next 10 years. I'm also expecting higher commodities prices as well.

By appreciation, do you mean rent appreciation or property value appreciation? They aren't exactly the same thing. Rent appreciation should generally mean property value appreciation, but property value appreciation could also be driven by cap rates tightening. So, as a rule, rent appreciation means property appreciation, but property appreciation doesn't necessarily mean rent appreciation, although it certainly can.

Going along with my earlier comparison of CRE to a bond/fixed income security, looking at the value of a commercial property like the price of a bond, property price changes driven by broad market rent moves would be like a bond price move driven by rates, whereas a property price move driven by market cap rate changes would be like a bond price move driven by changes in spreads. So like... In the same way that a bond's price is a function of more than overall market rates, a property's price is a function of more than rent.

Anyways, there's a lot of elements at play when we're talking about real estate value. First of all - this 5% annual appreciation (I'm just going to use that word in this post without specifying rent or price unless it matters for my point, in which case I'll specify, because I'm not entirely sure which you mean) in Texas is likely going to be somewhere in the neighborhood of twice the rate of broader US economic growth over the same period, even in a pretty aggressive growth case. Are you really highly confident you're going to double the US growth rate for an entire decade?

Especially on an energy commodity story? I'm not an oil trader, but it's my understanding that energy prices are generally pretty cyclical / a function of manufacturing activity and broader economic strength, so it should be pretty hard for an oil/energy commodity based economy to outperform so substantially for such a long period of time.

Plus like... It's not like energy money in Texas is new. It's been one of the largest oil producing regions in the world since... forever, right? So... what exactly are we expecting to happen differently there that will cause future values in that market to significantly decouple from past? If anything, shouldn't we expect that Texas' upside in a long term commodity price appreciation case to be limited since it will become more worthwhile to produce in the tar sands and the bakken and shit which will take away the advantage to producing Texas light sweet crude? Like... There's only so expensive oil can become before new sources are tapped, which will stabilize price, so I think of Texas oil as like, similar to an equity that has had a covered call sold on it. There's only upside until the strike price of the call, and that strike price is the price of a barrel of crude that makes it economically viable to tap the tar sands. And I thought that all the nat gas plays have gotten totally smoked? Isn't there nat gas basically fucking everywhere and it's cheap as shit?

I don't know, energy speculation is way outside my area of expertise, so I don't really know about that play. Although I would have to ask where that 5% number came from. Like... directly out of your ass or did you somehow calculate it based on a set of reasonable assumptions? Why 5%? Why not 6%? Why not 4%? I would say that in the space I play in, most of the long energy plays people are making aren't in Texas. What makes you think Texas energy risk is inherently mispriced?

Also when we're talking about CRE, there's the bug fucking elephant in the room, the rates issue, that is this whole can of worms. Real estate values are driven by "affordability." That is to say - a combination of nominal prices, buyers' ability to obtain financing, the price of that financing, and the cap rate on that nominal price/amount of annual cash flow you can expect per dollar of building purchased.

In the world you're describing - a very strong economic growth case - you'd have to assume a high rate environment, right? By definition, Cap rate*property value > loan size*coupon rate, because first of all, no bank is realistically going to give you a mortgage at a

Plus, you have to take into account this concept of "infill." Real estate values don't increase in a bubble - as rents raise and cap rates tighten, developers build and businesses move to the 'burbs. In The markets you're describing, you've got miles and miles of undeveloped land, and limited reasons that the currently developed land is somehow "different" from the undeveloped. There's ony so strong the market can get before its flooded with excess supply, so the effect is similar to the covered call scenario I described above with respect to energy prices. Once a certain "strike price" is reached, that is, a certain PSF value that is higher than the PSF cost of new development, new developments will be built, putting downward pressure on existing product.

So yeah, I think the upside in the real estate is more limited than you are giving it credit for being just because there are more factors at play in real estate than raw commodity prices' effect on commodity driven markets. Like, teres just a lot more at play here than the story youre telling about a commodity boom driving Texas growth (at double the national average for the mext decade no less.)

Plus, if you're arguing for a fundamental mispricing in a given market, you'd better have a pretty good fucking argument. There's this concept in economics where if you walk into a room with 1,000 people, all bidding on a given asset, and you win - you probably overpaid. That means you valued it higher than 999 other people. Not a good sign. In this case, bidding on real estate, you are saying most players in Texas are wrong and you are right. That should make you think twice - for every Paulson that bets against the market and wins, there are thousands of losers you never heard of that got blown up doing the same thing. Even if you're vindicated in the end, the market can eat up all your capital a lot faster than your story can play out if you time it even slightly wrong, and that's out of your control. Nobody can say exactly when the hammer will fall even if they see something coming a mile away.

So yeah, I don't think your story is necessarily wrong or poorly analyzed, I just wouldn't give you any capital because I think that you have sort of one good story that you're focusing on - long commodity - and you're ignoring everything else. You don't get to do that, world will slap you hard in the jaw.

Aug 8, 2013

Solid write-up NYCBandar, sounds like someone is dumping adderall into your water coolers. I like Texas mainly due to population growth and job growth outside of energy. We underwrite 3% growth for long term properties in California, 5% isn't preposterous.

(http://www.census.gov/newsroom/releases/archives/p...)

(http://www.bizjournals.com/austin/blog/abje_news/2...)

I think 7ombuiler in Bhopal is getting my money though

Aug 19, 2013

Sorry for my recent absence from WSO.

But very nice posts NYCbandar. No, I do not have any models I've used for my 6% number and like I said I'm a real estate noob. I mainly base that number off my bullishness for the energy industry. My view on the industry is pretty consistent with T. Boone Pickens and Limits to Growth. I see fracking as a temporary solution to a long term problem and I see oil and natural gas getting exponentially more expensive in the years to come, which is why I am bullish on Houston/Texas real estate, despite not knowing shit about the real estate industry. Plus, as GP said, population growth and job growth outside of energy should serve as catalysts for growth as well.

Competition is a sin.

-John D. Rockefeller

Aug 19, 2013
Comment