Cap rates are only telling part of the appraisal story
We find ourselves today amid a period of macroeconomic headwinds, elevated interest rates and banking turbulence, but this combination of factors doesn’t mean commercial real estate professionals should be approaching asset valuation without confidence and specificity.
Not since the mid-2000s (and the late 1980s before that) have we seen the Bank of Canada boosting interest rates so sharply and consistently as it has been recently. We see questions all around us:
- Have lending rates peaked yet in Canada?
- What will happen with access to credit given the recent turmoil in the banking industry?
- Can Canada fend off a recession?
- Which asset classes in the commercial real estate market will experience the most demand in the coming months and years?
Regardless of these questions and broader market conditions, evaluating and pricing assets, whether they’re industrial, office or retail properties, will always rely on a bit of art and a bit of science — and it's essential for appraisers to get the formulas right to ensure your asset is appropriately assessed and positioned in the market.
Cap rates tighten, but that’s only part of the valuation picture
Market expectations have changed during the past year. We’re now seeing rising or flat cap rates for nearly every asset in every market.
While it’s likely we’ll see flattening interest rates through 2023, we do expect to see some continued or residual belt-tightening in the Canadian market.
Many commercial assets, including various retail, suburban office and downtown office assets around the country, have experienced cap rate expansion, something not seen on such a broad scale in recent memory.
When it comes to valuation, cap rates are only part of the picture.
Rising interest rates do not necessitate a basis-point-for-basis-point expansion of cap rates and interest rates are only one variable that influences property metrics.
While the spread between cap rates and interest rates is at historic lows, over the last 20 years, there has been a significant institutionalization of real estate ownership, unlocking efficiencies and reducing the so-called “risk premium” commanded by real estate over safer alternatives such as government bonds.
A bigger challenge for owners of commercial real estate is to ascertain a holistic, realistic and accurate valuation in the low transaction environment that we find ourselves in today.
Deals lag in office, but market remains balanced in industrial
From an asset-class perspective, we're seeing low deal volume in the large-scale office market. That's understandable as companies continue to experiment and recalibrate their return-to-office work situations.
There's currently a wait-and-see approach occurring with office tenants and their workers in Canada’s big cities.
On the other hand, high-quality industrial assets continue to exhibit a higher level of resiliency in the face of increasing capital costs.
In the period leading up to this era of elevated interest rates, we'd typically see attractive industrial assets receiving strong market interest with a deep field of competitive bids.
Now, those same assets are attracting two to three qualified buyers coming to the table. It's not quite as frothy, but demand remains healthy and vacancy is at historic lows.
In retail, well-located centres anchored by necessity-based tenants like grocery and pharmacy are showing muted market changes compared to unanchored assets or those in peripheral markets.
A growing population and persistently high homeownership costs mean the rental apartment market remains strong nationally.
Holistic valuation requires art and science
It's essential to bring to the table both broad and diverse client experience and background to help corral market sentiment.
That means putting in the leg work to speak to stakeholders from various buyer and seller camps to understand how they're looking at their own asset base; how they’re underwriting current acquisition opportunities; and how they're assessing dispositions in the market.
It's also about doing the homework on the deals that do happen so you can understand the back stories.
The devil is in the details with many transactions in today’s market, ranging from assumed financing at below-market interest rates to favourable vendor take-back terms to mitigate purchaser capital outlay.
In a low-transaction environment, the valuation and appraisal process requires some "art" and some "science."
We can still complete reliable valuations by leaning on our network, talking to vendors, buyers, lenders and basically everyone on the front line of a property deal. That's the “art” that helps us understand what is going into that purchase or sale decision.
The “science” requires analyzing what the market and the numbers are showing us. We're looking at interest rates and how they underpin cap rates, but also recognizing that cap rates only tell part of the story.
Good valuation math also means being able to assess those metrics and then transfer that data into a dynamic tenure cash-flow model that is more regimented and less open to interpretation.
In this environment, there is rarely a one-size-fits-all answer.
Valuations in markets like these don’t need to be scary
In market conditions like these, you tend to see two main camps form: the "business as usual camp" and "the sky is falling camp," but neither is completely right in its assessment or approach.
Saying values haven't changed because there haven't been many deals entails missing key parts of the puzzle, while saying that cap rates have surged 400 basis points because interest rates have gone up by 400 bps also paints an incomplete picture.
It's essential for appraisers to look at things through a dynamic lens.
The truth is that the centralization and institutionalization of commercial real estate has mitigated many of the risk factors seen the last time the market went through a rate expansion cycle and this is not the time to put our heads in the sand.
This is especially true now that the Bank of Canada has essentially paused its rate-hiking cycle. We can now anticipate some stability and predictability to return to the market, likely prompting more reliable, consistent deal activity.
Expertise and due diligence provide a strong foundation for reliable commercial real estate underwriting in today’s environment.
Each transaction and asset provides a piece of the market puzzle, and understanding both the macro and micro factors takes the uncertainty out of valuations in today’s commercial property landscape.