Commercial Real Estate Prices Still Have Room to Run, According to First American Potential Capitalization Rate Model

—Commercial real estate price growth could continue to outpace commercial real estate income growth, implying property values may not yet have reached their cyclical peak, says Senior Commercial Real Estate Economist Xander Snyder—

SANTA ANA, Calif.--(BUSINESS WIRE)-- First American Financial Corporation (NYSE: FAF), the premier provider of title, settlement and risk solutions for real estate transactions and the leader in the digital transformation of its industry, today released First American’s proprietary Potential Capitalization Rate (PCR) Model for the fourth quarter of 2021. The PCR Model estimates capitalization rates based on the historical relationship between interest rates, rental income, prevailing occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends.

Commercial Real Estate Economist Analysis: National Capitalization Rate at 20-Year Low

“Nationally, the average capitalization (cap) rate across all commercial real estate asset classes (office, industrial, retail, multifamily, hotel, and senior housing) is at a 20-year low, due to today’s low interest rate environment and the limited supply of commercial real estate properties relative to strong post-pandemic demand,” said Xander Snyder, senior commercial economist at First American. “Commercial real estate (CRE) investors have bid up prices to own the stream of income that commercial real estate properties can provide. Is it possible for prices to continue to increase? Or will inflation and a rising interest-rate environment reverse the long-term decline of the national cap rate and reduce the pace of price appreciation?”

Introducing the Potential Cap Rate Model

“To help answer this question, we developed the First American PCR Model, which estimates a potential national cap rate based on several CRE market fundamentals, including rental income, prevailing occupancy rates, interest rates, the amount of commercial mortgage debt in the economy, and recent property price trends,” said Snyder. “When the actual cap rate is significantly above the potential cap rate, as was the case in the fourth quarter of 2021, the model suggests that the CRE market can support a lower cap rate.”

Do Commercial Real Estate Prices Have Room to Run?

“Except for a brief hiatus during the Great Recession (2007 to 2009) when property prices declined and real estate investment risk was high, the national average CRE cap rate has consistently declined. Since the end of 2017, the potential cap rate has been below the actual cap rate because declining interest rates have reduced financing costs and increased buying power for CRE investors,” said Snyder. “In the fourth quarter of 2021, the actual cap rate reached a record low of 5.2 percent, while the potential cap rate, according to the PCR Model, was even lower at 4.4 percent. This implies that CRE price growth could continue to outpace CRE income growth and that property values may not yet have reached their cyclical peak."

“As the Federal Reserve raises interest rates, financing costs are likely to increase and reduce CRE demand. The potential cap rate, as supported by market fundamentals, may be as low as it can go,” said Snyder. “However, since the actual cap rate remains above the potential cap rate, the actual cap rate could still go even lower as CRE investors compete with each other for the income streams that commercial real estate provides.”

Fourth Quarter 2021 Potential Cap Rate

For the fourth quarter of 2021, First American updated its proprietary Potential Cap Rate Model to show that:

• Nationally, the potential cap rate was 4.4 percent, a decrease of 0.3 percentage points as compared with the third quarter of 2021.
• The potential cap rate decreased by 0.2 percentage points as compared with one year ago.
• Currently, the potential cap rate is at its lowest level in more than 20 years, at 4.5 percentage points below its third quarter 2001 peak of 8.9 percent.

Cap Rate Outlook Gap

• In the fourth quarter of 2021, the national actual cap rate was 0.7 percentage points higher than the potential cap rate, suggesting that the actual cap rate could decline further.
• The gap between the actual cap rate and the potential cap rate increased 0.3 percentage points between the third quarter and fourth quarter of 2021.

Next Release

The PCR Model is updated quarterly with new data. Look for the next edition of the PCR Model the week of June 27, 2022.

About the Potential Cap Rate Model

The Potential Cap Rate (PCR) Model estimates cap rates based on the historical relationship between interest rates, rental income, prevailing occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends. The PCR Model uses these metrics to establish a potential cap rate level that is supported by these market fundamentals. When actual cap rates are significantly above the potential cap rates, there is a greater chance actual cap rates will decline. Conversely, when actual cap rates are significantly below the fundamental cap rate level, there is a greater chance actual cap rates will increase. Potential cap rates are aggregated nationally and include all major asset classes: multifamily, retail, industrial, office, and lodging. The PCR Model is updated quarterly.

A cap rate is a measure of estimated yield, or the return, on an investment property assuming no debt is used to purchase it. Cap rates are calculated by dividing an asset’s net operating income (NOI) by its value. NOI is income leftover to an owner after covering operating expenses, but before servicing debt. Since cap rates do not take debt service into consideration, cap rates are a measure of what is called unlevered yield.

Disclaimer

Opinions, estimates, forecasts and other views contained in this page are those of First American’s Chief Economist, do not necessarily represent the views of First American or its management, should not be construed as indicating First American’s business prospects or expected results, and are subject to change without notice. Although the First American Economics team attempts to provide reliable, useful information, it does not guarantee that the information is accurate, current or suitable for any particular purpose. © 2022 by First American. Information from this page may be used with proper attribution.

About First American

First American Financial Corporation (NYSE: FAF) is the premier provider of title, settlement and risk solutions for real estate transactions. With its combination of financial strength and stability built over 130 years, innovative proprietary technologies, and unmatched data assets, the company is leading the digital transformation of its industry. Tracing its heritage back to 1889, First American also provides data products to the title industry and other third parties; valuation products and services; mortgage subservicing; home warranty products; banking, trust and wealth management services; and other related products and services. With total revenue of $9.2 billion in 2021, the company offers its products and services directly and through its agents throughout the United States and abroad. In 2022, First American was named one of the 100 Best Companies to Work For by Great Place to Work® and Fortune magazine for the seventh consecutive year. More information about the company can be found at www.firstam.com.

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Source: First American Financial Corporation