What Exactly is a Cap Rate and How Does COVID-19 Impact Them?

By Jerry Heaton 

For the past 35 years, I have been involved in the valuation of commercial real estate.  As a Department Head at the FDIC during the worst banking and savings and loan crisis (1985-1995), I reviewed thousands of appraisals on billions of dollars of commercial real estate which was foreclosed upon during the $80 billion banking crisis.

The valuation of real estate on properties foreclosed upon by banks is a useful reference to what we could see again in the near future, due to COVID-19.  The primary tool used in commercial real estate is a cap rate.  I have taught the fundamental concepts of cap rates to everyone from bank asset managers to fellow tax consultants over the course of my three-decade career as a professional Tax Consultant. So, you could say that I have a unique perspective on the basic underlying correlation of cap rates, risk and uncertainty.

That’s why I am sharing what I like to call Cap Rate 101 for laymen. Once the concept is understood, it’s easy to apply them to COVID-19 and its’ impact upon cap rates by using past experience as a basis. So, let’s get started.

 

Cap Rate 101

What is a cap rate in laymen’s terms?     

If an investment property costs $1 million dollars and it generates $75,000 of NOI (Net Operating Income) per year, then it has a 7.5% CAP rate. Traditionally, different CAP rates represent different levels of risk. 

Low CAP rates imply a lower risk while higher CAP rates imply higher risk. 

To simplify it even further, let’s consider this scenario. You inherit $1,000,000 and have to decide where to put it.  The basic formula for valuing a property is Net Operating Income (NOI)/Cap Rate (risk) = Value.

If you simply put the $1,000,000 under your pillow, your risk is zero, but your return is also zero. It’s low risk but you also receive no return on your investment.

Now let’s say that you put that $1, 000,000 in your savings account. The return might be 1% of interest which would equal approximately $10,000 per year.

If you put that $1,000,000 in a CD (Certificate of Deposit), the return might be 2%. However, that comes with a small risk if you find yourself needing the money before the CD matures. But if you can wait until maturation, you stand to earn $20,000 profit off of your investment.

But what if you used that $1,000,000 to invest in commercial real estate? There are certainly plenty of options and each one has different risk and returns. These are some examples from before the onset of the COVID-19 virus. 

Investing in newly built, high-occupancy multifamily properties (apartments) has usually been seen as a solid lower risk investment by many investors.  Before the appearance of COVID-19, investors may have purchased an apartment property for $1,000,000 and could have expected a return of $50,000 per year, which would be equal to a 5% cap rate. 

The basis of this investment is that there is lower risk with high probability of the apartment occupancy remaining stable, rents steadily escalating. Therefore, your money is generating more than it would sitting under that pillow or in a CD. 

But how has COVID-19 changed this equation?

If the economy shuts down, stocks drop 30%, unemployment climbs to 20%, wages drop, retail stores shut down and restaurants close, who are the most likely impacted?  People who live in apartments are the most likely to be impacted by those aforementioned events.

If that is the case, what is the likelihood of occupancy staying at 98% and rents climbing 5% every year for the foreseeable future?  Has the risk related to buying an apartment complex increased?  

Is a 6% or 7% or 8% cap rate more in line with the risk related to these events playing out? Only time will tell. Based upon my experience, the cap rate and risk of all real estate investments will continue to climb until the economy completely recovers in the aftermath of COVID-19. 

But what about investing in a single-tenant industrial building?  The industrial sector has been doing very well to meet the demands of the Amazon-driven online buying trend.  The risk related to this scenario clearly revolves around one issue.  Who is the tenant and what is the likelihood of this tenant paying rent?

Let’s say the tenant is an Amazon seller who relies upon inventory coming in from China. 

Before COVID-19, that risk would be lower than it is now.  Imports from China and Italy and other countries have been impacted by the virus and it is possible that this tenant may not be able to pay their rent in three months due to a lack of inventory.  So, where the risk rate on this investment was around 6% before the virus, it could now run around 8% or higher. Remember that higher risk means higher cap rates and those higher cap rates mean lower values. 

I believe that the sector hardest hit by COVID-19 is retail.  Retailers, who were already struggling before the onset of this virus, are closing doors at a record pace.  The spread of the virus and social distancing protocols has actually helped out online merchants.  People are now forced to shop online to avoid contact and many are doing so for the first time ever.

I have a brick and mortar retail client which was trading on the NYSE at $25.00 a share last year this time.  As of yesterday, they were trading at $1.80 per share. During the FDIC banking crisis, it was common for us to see 10% and higher cap rates on real estate.  My prediction is that those type of cap rates will return and the retail sector will be the first to hit 10% cap rates since the late 1980s and early 1990s. 

Finally, the concept of high risk vs. high return is best understood by looking at the stock market. Over the last four years, the stock market (Dow Jones) has climbed from roughly 20,000 to 30,000. This meant that 401Ks have experienced record increases in year over year returns.

But with the higher risk of higher returns, there is also a higher risk of zero returns and even loss of the principal investments.  The dwindling value of 401Ks will shock the economy to the point where people are exceedingly cautious and will in turn spend less in virtually every aspect of their life.  Car buying will be put on hold, house buying will be put on hold, lower rents will be sought out and retailers will continue to shut doors as buying levels go down.   

For now, my prediction is that property tax valuation models will shift the cap rates up at least 2 to 3 or more percentage points, bringing them to a 8% -10%+ range.  To give that some perspective, during the Savings and Loan Crisis of the 1980s, I reviewed some appraisals with cap rates nearing 20%.   This is the first time since 1985 that I have seen so many reasons for the downward shift of real estate investments, all caused by COVID-19 and the market reaction to the virus.  

That’s why the property tax professionals at Paradigm Tax Group are here. In order to help commercial real estate investors, we can use our team of property tax professionals to analyze the potential high risk of all investments, including a realistic look at potential future cap rates in the wake of COVID-19.

As you are aware, we are all facing an unprecedented health event involving COVID-19. We here at Paradigm Tax Group consider the safety of our employees, as well as our clients, our top priority. We want you to know that during this major event, we are still open for business and ready to serve the property tax needs of all of our clients and will do so with the health and safety of everyone concerned at the top of our minds. READ MORE…

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