We are currently representing a buyer who’s in the market for a commercial building, condominium or cooperative. As I’ve been scouring the market, I’ve noticed that sale prices have increased dramatically over the past year. However, rental rates for retail property have gone down over the same period.
Interest rates have been so low for so long that there seems to be a disconnect between rental rates and sales prices (i.e., a bubble). This is reflected in the fact that sellers are asking for capitalization rates under 5%.
The capitalization rate is the rate of return on capital costs based on the income the property is expected to generate. For example, if the rent on a property you bought for $2,000 is $100, you are receiving a 5% return. The capitalization rate is the inverse of this, a 5% capitalization rate on $100 of income is $2,000. It will take you 20 years to get your $2000 investment back. Buying property at a 5% capitalization rate can be extremely risky due to market volatility and the prospect that your tenant may go out of business and reduce your return. The actual situation for buyers today is even riskier, because (as noted above) capitalization rates for retail properties are currently under 5% (20+ times the income). Rates of return have decreased (capitalization rates have increased) as rents have gone down.
The disparity in the market between high purchase prices for retail properties and lower rental rates suggests that something has to give: either rental rates have to rise, prices have to come down or something else may be at play.
Contact GE Grace to learn more.
George E. Grace
G.E. Grace & Company, Inc.
232 Madison Avenue
New York, NY 10016