Published on Friday, May 3, 2024
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Using different valuation mechanisms can be useful during volatility, limited market liquidity, and reduced transaction volumes.
A funny thing happened on the way to the loan department: Someone asked for a property valuation, and nobody could agree on what it should be.
Many lenders are wary about financing CRE. Yes, there are the concerns about property types like office and multifamily. Everyone worries about where inflation and, therefore, interest rates might go. And property values keep dropping.
But even as valuations fall, few have a tight handle on what a building is actually worth. Greatly slowed transaction rates at times when a lot of property owners are trying to bail out of a bad refi position mean getting comparables is tough. How much financing can a building support? Can the business plan work in the long run?
Traditionally, appraisal-based cap rates have been the preferred method to get a sense of how to answer those questions. However, under current conditions, that sort of estimate is harder to pin down with enough accuracy.
CBRE recently explored some alternative approaches to cap rates and property valuations:
- Spread-Implied Cap Rate — take the average historical spread of cap rates over 10-year Treasury yields to find the current property yield.
- Fair Value Cap Rate — use the Gordon Growth model by adding the risk-free rate and risk premium and then subtract expected income growth.
- Debt Service Coverage Ratio (DSCR) Implied Cap Rate — look for the yield that will allow the property to get an adequate DSCR.
- REIT-Implied Cap Rate — compare current REIT share prices and a property’s expected income.
The firm then applied each of the methods to office, multifamily, retail, and industrial, comparing them to appraisal-based cap rates. Here are the implications that CBRE saw:
“Office cap rates may have more room to rise.”
“The rise in industrial cap rates may have peaked. (Notably, the spread-implied rate is markedly higher than the yields computed using other methodologies, likely due to the recent boom in capital flows into industrial.)”
“Current fair-value cap rates are low for retail, implying the sector may enjoy some downward pressure on yields.”
“Signals for the multifamily market are mixed, hinting that the outlook for pricing can vary depending upon market and asset selection.”
Which particular method is most accurate is still terribly hard to say. But the combination can give a wider context and deeper insight into how market conditions and valuations can interplay.
