Outperforming Rent Growth Keeps Driving Mark-to-Market Opportunities
Built in 1997, this distribution center at 101 N. 103rd Ave. in Tolleson, Arizona, was sold as part of Prologis’ $3.1 billion portfolio acquisition from Blackstone. (Brandon Aran/CoStar)Since the U.S. Federal Reserve began tightening monetary policy in March 2022, commercial property values have been declining across every major commercial real estate sector as higher borrowing costs and slowing rent growth limit what investors are willing to pay for new acquisitions.
However, capitalization rate increases for industrial properties have paused for now, and continued capital flows into the sector may contain future increases indefinitely.
Cap rates are one of the primary methods investors use to value income-producing real estate as they reflect the property’s initial all-cash yield, and are often compared to the income derived from a bond.
Higher cap rates in any property sale typically signal a buyer’s caution over a higher level of perceived risk to that property’s potential to generate future income. In contrast, lower cap rates reflect buyer confidence in the security and growth potential of that property’s future rent payments. As a result, falling cap rates are typically associated with rising property values, whereas rising cap rates often reflect investor expectations that the property’s value may decline.
This year, cap rates tied to most commercial property sales have been rising, while cap rates of large industrial property sales have remained stable as buyers continue to expect future rent growth.
The trailing six-month average cap rates for sales of U.S. industrial properties larger than 50,000 square feet was 5.4% at the end of June, in line with the low end of today’s financing costs. That was up only 20 basis points from the 5.2% at the beginning of the year. In contrast, average cap rates for sales of comparably sized apartments and office buildings over the same time increased by 60 and 120 basis points, respectively, reflecting the growing trend of negative rent growth in each of those property types.
Owners of publicly traded real estate investment trusts, or REITs, also signal outsized confidence in the resilience of industrial property values and rent growth potential compared to other property sectors.
According to data from the National Association of Real Estate Investment Trusts, implied cap rates derived from the net operating incomes and share prices of industrial-focused REITs increased from an all-time low of 2.9% in late 2021 to 4.6% by the third quarter of 2022. Since then, share prices of most industrial REITs have rebounded, allowing their implied cap rates to decline 50 basis points to 4.1% through early 2023.
In contrast, implied cap rates among office-focused REITs have begun to price in the sector’s dual headwinds of deteriorating leasing demand and cycle-high supply completions and are continuing to reach new highs.
In response to the higher cost of capital compared to the first quarter of that year, implied cap rates of apartment-focused REITS have remained stuck at cycle-peak levels reached in late 2022.
As the multifamily sector’s implied yields more fully reflect a risk premium from decades-high imbalances between supply and demand, increased capital flows could make their way into the industrial sector and put a ceiling on how high cap rates climb in the sector.
Despite the trend of decelerating industrial rent growth, the sector still outpaces competing property types and therefore continues to attract new investors. Historically, capital flows tend to outweigh supply and demand relationships and could contain future cap rate increases relative to other property types.