In a recent posting, Ottawa-based accredited mortgage professional Allan Jensen of the Dominion Lending Centres
discussed the relationships between the recent cap rate compression and risk in commercial real estate investment.
Defining the cap rate as “the ratio of rent paid by your tenants, to the price/value of the building,” Jensen stated that this metric remains “an important barometer on the current state of the market.”
“Cap rates are inversely related to value. As the price/value goes up, the cap rate decreases. Falling prices infer the inverse is true,” he explained. “[Increases] in property income are a major driver of value, and consequently of lower cap rates. Furthermore, cap rates reflect the risk free return plus a risk premium, less the growth in long term rental income.”
“The components which enter into an assessment of the relative risk of a real estate investment of course include financing costs. These costs are directly related to bond yields, as Government Bonds often are held to be the ‘risk free’ investment alternative for institutional lenders,” Jensen added.
And since bond yields are presently at record-low levels, does the current downward movement in cap rates mean that investors are now impervious to risk?
“I am starting to think that there is a continued bifurcation in the market. Off shore investors have a different take on ‘risk free’ investing it seems. They are often larger players, likely have greater access to less expensive funding, and perhaps more importantly, have a longer term investment horizon.”
However, Jensen warned that the market is an unconscious entity that does not “differentiate between local and offshore buyers.”
“Cap rates reflect buyer sentiment. In this increasingly global marketplace, domestic investors are of necessity on the same playing field with larger off shore investors. The result seemingly is a continued cap rate compression. By some accounts this reflects an absence of a risk premium, or at the very least, a difference of opinion as to what constitutes risk.”
Commercial segment can expect continued strength for the rest of the year – report