PART 2ST. LOUIS COMMERCIAL REAL ESTATE ISSUES

PART 2ST. LOUIS COMMERCIAL REAL ESTATE ISSUES

CAP RATES:What Do They Mean & Why Do They Matter?

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St. Louis Commercial Real Estate Issues, Part 2 - CAP RATES: What Do They Mean & Why Do

They Matter? is published by:

Intelica CRE

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Chesterfield, MO 63017

Intelica CRE is a St Louis based nationally operating company specializing in commercial

real estate services including tenant representation, project leasing and sales, property

management, corporate services, capital markets, development services, and research. By

building on our strong foundation of intellectual capital, Intelica delivers value to owners,

investors and users of commercial real estate. Intelica manages and leases space in nine

national markets comprising of more than 4 million square feet valued at approximately $450

million.

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Disclaimer: This report is designed to provide general information in regard to the subject matter

covered. This report does not constitute an offer to sell or a solicitation of an offer to buy any

services, and the authors of this report advise that no statement in this report is to be construed as

a recommendation to make any real estate investment or to buy or sell any security or as investment

advice. Neither Intelica CRE, nor any of their respective directors, officers, and employees warrant as to

the accuracy of or assume any liability for the information contained herein.

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About This Study

The commercial real estate industry has struggled during the “Great Recession,” and the St. Louis market is no exception. During the recovery, there will be continued issues that will affect the commercial real estate industry.

In a 4-part series, Intelica CRE will outline a few of these issues and instruct the savvy investor on what to expect moving forward. Intelica will focus on the issues of employment growth, the current state of CAP rates in St. Louis, local real estate liquidity and the growing technological impact on the commercial real estate industry. Part 2 discusses cap rates and what they mean to a real estate investor.

ST. LOUIS COMMERCIAL REAL ESTATE ISSUES: PART 2

CAP RATES: What Do They Mean & Why Do They Matter?

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Cap Rate Rationalization

Cap rates are generally accepted as the benchmark for analyzing a real estate investment opportunity.The United States is currently experiencing near record-low cap rates in every market sector. The St. Louis Metropolitan Statistical Area (MSA) is no exception. In fact, St. Louis has lower office, industrial and retail cap rates than the Midwest average.

Source Year Market Product Type

St. LouisCap Rate

Midwest Cap Rate

National Avg Cap Rate

Integra Realty Resource 2013

Suburban Office Office

7.5 8.27 7.91

8.25 8.39 7.65CBD

CoStar 2012 MSA Office --- --- 7.91

CoStar 2012 MSA Industrial 7.5 8.32 8.21

Reis Report 2012 MSA Retail 8.7 --- 8.01

Every real estate investor has several arbitrary ways to determine a cap rate. We’ve all heard the savvy investor brag about the great real estate investment: 25% cash on cash, 15% cap rate and a great A+ tenant. On the flip side, we’ve heard the water cooler conversation about an investor who paid a 4.0 cap rate for a Triple A Credit tenant on the corner of no-where and no-where. When the “Triple A Credit” tenant leaves in 10 or 20 years, that investor who overpaid for the brick and mortar value may never recover financially.

A cap rate is a rate of return on a real estate investment property based on the expected income that the property will generate in the first year of investment. A cap rate is used to estimate an investor’s potential return on his or her investment.

Cap rate is determined by dividing the Net Operating Income of the Property (after fixed & variable costs) by the Contract Purchase Price.

Net Operating Income

Purchase PriceCAP RATE =

Other Factors to Consider When Investing in Real Estate

Cap rates are a good jumping-off point to quickly compare investment opportunities, but they should not

Growth or decline of potential incomee.g. occupancy rates, rent rates

Vacancy reserveMoney to cover operating expenses & carrying costs during vacancy

Property valuee.g. inflation, vacancy rates, appreciation, deflation

Capital reserveMoney for a rainy day

Capital improvementsRoof repairs, parking lot, restroom cleaning, HVAC, plumbing, capital for future, code violations, etc“No one told us we needed a sprinkler system for $100,000!”

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What Happened to My 25% Return?

The aforementioned illustrates complexities involved when analyzing a real estate investment. So in short, here are some things to always keep in mind when looking to invest in real estate:

1. Never buy without an exit strategy.

2. Know your risk tolerance.

3. Get a grasp on values: past, present and future lease rates and sale prices.

4. Seek professional advice.

Remember: All went terribly wrong in 2007, even though things were going well previously.

So, Why Invest in Real Estate?

According to JP Morgan Asset Management, in the current financial climate, traditional bonds and equities are forcing investors to compromise for low risk and low return or enhancing return at the expense of higher risk. This is not true for real estate investments. Real estate is increasingly viewed as an essential component to any portfolio.

Treasuries and other investment grade bonds are still the safest assets; however, yields are at or near historic lows. On the other hand, equities (stocks or other ownership-like interests) are forcing investors to elevate their risk portfolio to experience premium returns. Alternatively, according to Oppenheimer Funds, real estate investment vehicles – such as REITs – have outperformed both stocks and bonds over time and are continuing this trend. The reason being that real estate returns are underlined by bond-like-yields, which increase with cash flow growth instead of returns being supported by a fixed coupon payment.

Inflation

Inflation is an important factor to consider when investing in real estate because it affects all factors of the economy. Popular opinion is that real estate is an inflationary hedge in low-interest rate environments. According to Kohlberg Kravis Roberts (KKR), inflation is currently not a threat. The Bureau of Labor Statistics reported that inflation increased 1.7% from December 2011 to December 2012. The Urban Land Institute projects inflation to slightly increase to 2.0% for 2013 and 2.5% in 2014. According to the Federal Reserve, these projected inflation rates will foster price stability over the medium term, which is desirable for real estate investments.

The concern is the Federal Reserve bond-buying program and a federal funds rate close to zero will increase inflation rates. Sound economic theory on inflation suggests that holding nominal interest rates below nominal GDP is almost inflationary over time. Even in this environment, real estate will hedge investment risks and continue to produce consistent yields. Using quarterly data from 1978 to 2011, Dr. Martha Peyton found a correlation between commercial real estate returns and inflation. When vacancy rates are high, the correlation is not as strong; however, this correlation is higher than other asset class.

Now for the boring stuff...

Keep reading because all avenues lead to making more money!

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Inflationary fears, though, are not substantiated by the majority of current, primary sourcing, market literature. Keep in mind that Treasury Inflation Protected Securities (TIPS) currently generate negative yields, according to the U.S. Treasury Department. Thus, any inflation-stable investment with a positive yield should be compelling.

Wake up! Read the above 3 times. In summary: Invest in real estate.

Treasury Rates

In ING Real Estate’s Q2 2010 research report, they stated, “Excess cap rate spreads (over 10-year Treasury rates) historically proved to be opportune entry points into the U.S. real estate” market.

Since treasury bills are risk free, they serve as a benchmark for all other investment opportunities, including commercial real estate investments. Ten-year Treasury Rates are currently valued at 1.88% (as of February 27, 2013). The Urban Land Institute projects treasury rates to increase marginally with rates of 2.3% by the end of 2013, and 3.0% by the end of 2014.

As discussed previously, real estate is a relatively safe asset investment with returns outperforming other classes. Currently, cap rates are relatively low implying less risk associated with the investment. The spread between the cap rate and the ten-year U.S. Treasury yield is one standard deviation above its average since 1978 (KKR, 2012); implying outstanding returns in comparison to risk-free assets.

For instance, the retail net lease market has an average cap rate of 7.25%, according to the Boulder Group. When comparing this to a risk-free rate of 1.88%, currently, the return spread is fairly substantial and the risk profile remains low according to historical figures. Or, a St. Louis industrial property at a 7.5% cap rate looks very good against current Treasury Rates.

If these treasury rate estimates are incorrect and rates increase KKR reports that the current spread between cap rates and the risk-free rate should act as an initial cushion. Thus, they believe that in the unlikely scenario the 10-year rate faces unexpected growth; consequences to the real estate industry will be softened by a period of “normalizing” the treasury-cap rate spread. Therefore, returns would decrease but stay fairly consistent to historical averages.

In conclusion, treasury rates can help an investor decide between risk and return involved in a commercial real estate investment. The data at hand suggests that real estate is a safe and sound investment, producing consistent returns moving forward.

Vacancy Rates

Vacancy rates directly affect the current operating income of a commercial real estate asset. As discussed above, any change in net operating income (NOI) will change the cap rate, as well; where NOI is revenue after operating expenses are deducted but before income taxes and interest are deducted. Additionally large vacancy rates shift the power to tenants when negotiating a rental rate, which also affects net operating income. St. Louis is currently experiencing excess supply of office space.

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Source Year Market Product Type St. LouisVacancy Rate

National Avg Vacancy Rate

CoStar 2012 Q4 MSA Industrial 8.4 8.8

PGI 2012 MSA Industrial 13.4 ---

Boulder Group 2012 Q4 MSA Industrial --- 8.15

CoStar 2012 Q4 MSA Office 10.7 12.2

PGI 2012 MSA Office 17.6 ---

Boulder Group 2012 Q4 MSA Office --- 8.04

CoStar 2012 Q4 MSA Retail 7.7 6.8

PGI 2012 MSA Retail 13.0 ---

Boulder Group 2012 Q4 MSA Retail --- 7.25

Nevertheless, as the recovery continues property values should increase and, generally, cap rate compression will endure.

However, cap rates tend to be a useful tool for the single-tenant leased property investor alone because multi-tenant properties have the potential to change NOI over time as tenants move in and out. Remember that cap rates are determined by first-year or going in income, a property will produce. Although cap rates are important, for a multi-tenant property, price per square foot and rental rates are a better measure for investment on these types of properties.

According to Principal Global Investors (PGI), rental rates, and thus NOI, have decreased 1.5 – 3.7% annually across the industrial, retail and office markets over the last 4 years. However, in a recent SIOR presentation on the St. Louis Metro Market Forecast more positive figures were reported. 2012 saw occupancy and rental rates both increased, on average, in the office sector. As well, SIOR reported similar trends in the industrial sector. Moving forward, compounded average rental growth is projected to grow 2.5 – 3.4% over the next 5 years for the office, industrial and retail sectors, according to PGI. Although, this will not bring normal rents up to pre-recession levels, it is consistent with the slow and steady recovery we

Open your eyes! Read the above once more. In summary: Buy real estate.

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As cited by J.P. Morgan Asset Management, “real estate can offer investors ‘optionality’ in a world of uncertainty-that is, the ability to participate in the capital appreciation associated with strong markets and the downside protection of a stable source of income in weak markets.” When deciding on an investment, there are many things to consider depending on the product type and class. While cap rates may be the historical standard for consideration, the savvy investor reflects on all aspects of the investment. Real estate can provide yield, growth and inflation hedging over time—especially in today’s environment. As the government continues to keep treasury rates low, there exists the potential to obtain a secure investment that will produce higher than average returns in the short run. In the medium to long-run yields should maintain their historical averages, which still outperform all other asset classes.

Conclusion

— BUY —

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References

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Dean Schwanke (2012). ULI Real Estate Consensus Forecast . [ONLINE] Available at: http://www.uli.org/wp-content/uploads/ULI-Documents/

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(2012). Viewpoint 2013. [ONLINE] Available at: http://irr.com/_FileLibrary/Publication/13/viewpoint2013.37pg.pdf. [Last Accessed 3/13/2013].

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John Corcoran (2012). REITs-The Rodney Dangerfield of Asset Classes. [ONLINE] Available at: https://www.oppenheimerfunds.com/

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(2009). Cap Rates and Real Estate Value Cycles: A Historical Perspective with a Look to the Future. [ONLINE] Available at: http://www.

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ContactIf you would like to discuss our findings in more detail, or to discuss your company’s real estate position, please contact us at 314.270.5991 or visit http://www.intelicacre.com