Do you opt for the recently constructed retail plaza with national credit tenants in a major market? This type of class-A asset sounds attractive except for the lower cap rate that accompanies all these features.
Alternatively, do you invest in older product with local tenants on shorter leases to obtain a better cap rate?
Each of these options have different borrowing costs and the gap between interest rate and cap rate, or investor yield spread, is worth examining.
I’ve once again dug into the First National database to search for valuable information. I’ve collected the appraisals from every retail refinance and purchase we facilitated in 2013. This provides us with a current cap rate for the property and I’ve contrasted this with the interest rate achieved in the same time period.
Assigning class-A or class-B status to each asset was less scientific. The difference between the two is a blend of building age and format, tenant mix, tenant rollover and geography. Since applying a numeric value to this is difficult, I made a judgment call on each property.
Most real estate professionals would agree
I’m sure I have my own biases, but most real estate professionals would agree with the divisions I drew.
As I tabulated the results I realized I did not know which group was likely to rise as the victor of the investor yield spread challenge. I decided to consult some retail brokerage experts for their predictions. David Williams and Yash Kumar of Colliers International had this to say:
“Overall, we believe that the buyers of class-B retail are ahead because in general the cap rate spread over the cost of borrowing is superior to class-A spreads. However, we have witnessed a number of class-B retail properties trade at cap rates equivalent to what is typical of class-A properties, but this is generally for properties under $5 million, where the private investors are most active.”
So the experts have picked class B, but noted some recent lows in terms of cap rates. I would agree with this observation. During my research I spotted several properties that had cap rates that were incongruent with what they were offering and bucked the trends that were developing in my calculations.
It’s now the moment of truth. Which asset will deliver the superior investor yield spread? It is class B, as predicted by the experts. Class-B retail assets enjoy a spread of 195 basis points while class A delivers 164 basis points. This 31 basis point difference represents a 19% increase in spread for class-B assets as compared to class A.
Investors interested in the future
This analysis is looking backwards and is informative, but investors really want to know what the future holds. I asked David and Yash for their near term cap rate forecast:
“Over the next 12 months we do not anticipate much movement in cap rates due to historically low interest rates. Over the next 24 months, we expect to see gradual increases in cap rates as a result of higher borrowing costs. There will be a 25-50 basis points increase in tertiary or secondary markets as the market shifts.”
We can expect a move in cap rates that is correlated to a rise in interest rates, but will they move in tandem? Will the numbers I’ve presented today look similar in 24 months time? Given the slow nature of the predicted rise in both cap rates and interest rates I would say yes. Not exact, but similar.
I posed one last question to David and Yash on this theme. How flexible are investors on the class of the retail investment they are buying? Would a rise in the investor yield spread of class-A properties excite a class-B investor (and vice versa)?
“There is a finite number of class A buyers at today’s cap rates and these buyers are not all that flexible to consider B-class product at this time. Class-B retail investors would not likely move towards A-class product if cap rates were to increase. A rise in cap rates would generally be across the board and B-class buyers would gravitate towards the higher yield in B-class product.”
I think this speaks to the human nature aspect of real estate investment; as long as the fundamentals don’t radically shift, people will stick with the asset class and risk level they are familiar with.
Adam Powadiuk is a Business Development Manager with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at firstname.lastname@example.org.