I am in no way, shape or form an economist, and if I knew everything, I wouldn’t be telling you about cap rates. I would be catching some rays on my yacht while I implement ground breaking investment strategies.

However, I do get a lot of questions about where I see real estate going in the future – what kind of investments we are looking at, and what the current state of the market is. As an investor, and a representative of those investing in commercial real estate, I will tell you what we see as a 30,000 ft view on the current real estate market.

Since the 1980s to around 2003, capitalization rates or cap rates lived in the 8-10% range. Cap rates are the percentage of return from an investment when you divide the Net Operating Income (NOI) by the price you are paying for the property. These expenses are taxes, insurance, common area maintenance, utilities, janitorial, etc.

 

Cap Rates

From the 1980s to present day, there have been several instances where cap rates and Treasury yields moved in opposing directions.

Around 2003, the cap rates dipped below, only to rise to the 8-10% levels in 2008 and 2009. Granted, some of your good and well located solid assets would trade in the 6% range for office product.

People knew how to play in this space, and if you lived in Dallas, Texas, the majority of the buyers were not international investors. They were primarily from the U.S. and Canada. Asian investors favored the West Coast and European investors favored the East Coast.

It’s no question that the real estate market is strong in Dallas. According to Integra Realty Resources (IRR) Viewpoint 2012 and Viewpoint 2014 cap rates in Dallas, TX for 2012 CBD Office Product were between 8.75% and 9%, and they compressed to 6.25% – 7% in 2015 for Class A&B CBD Office product.

According to the Costar Office Report for the First Quarter of 2013, the average Class A – CBD Office rate was $21.23/RSF, and the average Class B – CBD Office rate was $15.67/RSF. By comparison, the First Quarter of 2016, the average Class A – CBD Office rate was $25.53/RSF and the average Class B CBD Office rate was $20.36/RSF.

This was a huge swing, but the rates seem to have stabilized, as the same stats for the Year End 2015 were $24.61/RSF for Class A CBD Office Product, and $20.26/RSF for Class B Office Product.

This is going out on a limb to say they are stabilizing, but I find my clients having a hard time paying $40-$50/RSF for office space in Dallas, especially when they can go to other submarkets in the city and pay $20-$35/RSF.

 

cap rates

This chart shows that while 10-year Treasury rates and real estate cap rates have decreased, the spread between them has widened to 3.7%, above the long term average of 3.0%.

 

So if rates seem to have stabilized, why are cap rates continuing to go lower?

The answer lies in foreign investment. In November of 2015, Bloomberg published an article on Chinese foreign investment in the U.S., specifically in home investment. Chinese investors sent money overseas in order to seek safer investments. China’s economy is not growing as fast as it used to, and Chinese government could potentially take investors’ money.

Japan’s economy is somewhat flat with a weak outlook. If you live in Asia, investing in the U.S. is great because even though it is less profitable than it used to be due to the low cap rates, it is relatively safe, and still provides a return.

If you are a European investor, you want an investment that gives you a return.  Switzerland has negative interest rates, so in theory, if you give them money, at the end, you end up losing money.  Spain and Portugal are considering similar programs. Add a Brexit vote to the mix, and you quickly realize that Europe is not a good place to park your money. So investors send it to the U.S.

Now I know what you are thinking, “How many foreign investors are buying buildings in Dallas?” This past May 2016, KPMG Plaza sold to an Asian investment fund for near $500/RSF or about $225 million total. Mind you, it is 70% leased and quoting $34-$37/RSF NNN.  Let’s assume that they are receiving $34/SF on all of the 70% of the 459,383 RSF.  The Net Income would be $10,933,315.40.

This means that the building sold for a cap rate of 4.86%… Wow!  That is out of the typical U.S. 8%-10% investors wheelhouse. Additionally, $500/RSF is one of the highest prices per RSF that a building has ever sold for in Dallas. It is roughly twice what the market anticipates Chase Tower (55-story high rise across the street) will sell for.

Other talk is that the 21-story 2000 McKinney high-rise in Uptown Dallas will sell for a similar rate per RSF at $500. This building is also similar in size to the KPMG. However, it is currently 100% leased with two vacancies accounting for about 4.6% of the building coming available this summer. It is also quoting $40/SF NNN. So a building that has higher vacancy with lower rental rates will sell for the same price. It’s a crap shoot.