Investors that bought property at 4% cap rates and look to sell in the next few years at higher rates may find that the equity return will be in the single digits or negative. Many investors have justified these low cap rates by low financing rates and positive leverage. This is fine, but there is still tremendous terminal value cap rate risk. This will even be true if the NOI increases 3%-4% per year from robust rent increases. We have prepared a table below to show the effects on valuation of an increase in cap rates from 4% to 8%.

As shown in the table, if cap rates increase by 2% from 4% at acquisition to 6% at sale, the value of the property will decline by 33% (excluding any NOI increases for presentation purposes). If the increase in cap rates is more severe, going from 4% to 8%, then values decline by 50%. Approximately 70% of the IRR on a CRE investment derives for the sale or terminal value and the cap rate expansion shown above may negatively affect internal rates of return.

WALNUT CREEK, CA—As discussed in the Paramount Capital's monthly newsletter, View of the Market, relentlessly, the historical cap rate compression that has occurred in the CRE industry during the last few years. However, the firm's executive managing director, Joseph Ori, says in the exclusive commentary below that with the Trump election faster economic growth and inflation will be expected, both of which will force interest rates higher.

The views expressed below are the author's own.

During the Obama administration, the average GDP growth has been about 1.9%, one of the worst in the last century. If growth can be increased to a more normal 3.5% to 4.5%, the economy will boom and commercial real estate along with it. We could see the 10Y-Note increase from a current 2.3% to 3.5%-4% in the next few years. If this occurs, CRE investments and valuations will be negatively affected. Investors who bought property at low cap rates in the 4% area during the last couple years may have to sell into this higher interest rate environment and this could crimp returns.

There have been several articles written lately on the effects of a rise in interest rates on the CRE industry. Almost all have looked at past interest rate increases and the effect on valuations and concluded that CRE activity and values decline initially, but then rebound to more normal levels and there is little damage to the industry. We disagree with this analysis, as the country has never been in a period when short term interest rates have been zero for eight plus years. There is a big difference when short term interest rise from 50 basis points to 1.5% versus historically when they rose from say 5% to 6%. The percentage increase in the first instance is 200% while in the second instance is only 20%. Many real estate investors are addicted to these low interest rates and own property with rates floating at LIBOR plus a spread. Once market rates rise, these types of investors may experience sale or refinancing shock.

Investors that bought property at 4% cap rates and look to sell in the next few years at higher rates may find that the equity return will be in the single digits or negative. Many investors have justified these low cap rates by low financing rates and positive leverage. This is fine, but there is still tremendous terminal value cap rate risk. This will even be true if the NOI increases 3%-4% per year from robust rent increases. We have prepared a table below to show the effects on valuation of an increase in cap rates from 4% to 8%.

As shown in the table, if cap rates increase by 2% from 4% at acquisition to 6% at sale, the value of the property will decline by 33% (excluding any NOI increases for presentation purposes). If the increase in cap rates is more severe, going from 4% to 8%, then values decline by 50%. Approximately 70% of the IRR on a CRE investment derives for the sale or terminal value and the cap rate expansion shown above may negatively affect internal rates of return.