By the Numbers

Cap rates rise as commercial real estate sales crater

Mary Beth Fisher, PhD | June 23, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Capitalization rates for commercial real estate have climbed steadily for the past year as Fed hikes have put downward pressure on property prices. The interest rate volatility has also led to a dramatic drop in transaction volume, with commercial real estate sales declining toward levels last seen during the Global Financial Crisis. Liquidity should return in most sectors once the Fed signals an end instead of a pause in rate hikes. But the full re-pricing in office will take much longer, as workouts have so far resulted in more extensions than sales.

Capitalization rates based on transactions hit a low during the second quarter of 2022 for all property types (Exhibit 1). Given the long time it takes most commercial real estate sales to close, most of these sales were likely negotiated in late 2021 to early 2022, when interest rates were still at record lows and property prices were near their highs. The Fed began raising interest rates in March of 2022, and since then cap rates have steadily risen, heading towards levels of 2018 and 2019.

Multifamily cap rates have touched 6.0% this quarter, based on the transaction data available so far, which is about what they averaged in the two years leading up to the pandemic.
Industrial properties, which have continued to show steady demand, have seen cap rates rise from 6.0% to 6.5% over the past year, leaving them below the pre-pandemic levels of 7.0%.
Cap rates for retail properties touched a low of 6.0% in the second quarter of 2022 and have climbed a bit to 6.3%, still about 50 bp below their 2018-2019 average. Notably there are 78 retail properties in CMBS deals in various stages of foreclosure, according to CoStar. Many of these loans have already negotiated maturity date extensions, which allows the owners to avoid a distressed sale and a resulting price correction.
Given the extraordinarily dim outlook for the office sector, transaction cap rates don’t offer much insight. Like retail, that’s largely because many office borrowers and lenders are playing the extend-and-pretend game.

Exhibit 1: Market cap rates based on actual sales

Note: This is the straight average cap rate for transactions during the period for each property type. Data is quarterly, through 6/22/2023.Industrial property data begins in Q4 of 2000. Retail property transaction data begins in Q4of 2007.
Source: CoStar, Santander US Capital Markets

Over the past year, about 25% of properties listed for sale were later withdrawn from the market because the borrowers couldn’t get their price, according to CoStar. It’s unclear what the property breakdown is of the withdrawn sales, but both office and retail properties are likely to be heavily represented.

Liquidity dries up amid interest rate volatility

Commercial real estate sales have plunged, approaching lows not seen since the depths of GFC from 2009 through 2010 (Exhibit 2). Total sales volume recorded so far through the first quarter of 2023 is just over $50 billion. That’s a shade above what it was during the height of the pandemic in the second quarter of 2020, and in-line with levels last seen in 2012 to 2013. This quarter is shaping up to be even worse, with sales at $33 billion as we head into quarter-end. Sales are reported with a lag so these numbers do tend to rise over time, but large revisions are uncommon.

Exhibit 2: Commercial real estate sales

Note: Total sales volume of actual transactions, in billions of dollars. Includes allocated prices for portfolio properties. Data is quarterly, through 6/22/2023.
Source: CoStar, Santander US Capital Markets

The dearth of new origination should keep some downward pressure on spreads in the secondary market, where higher-rated classes have been stable to tightening across CMBS as BBB and lower-rated classes have drifted wider.

The collapse in office is just starting to materialize

Sales volume of office properties hit a recent peak of $37 billion in the fourth quarter of 2021 and have been steadily declining since, falling to $9 billion in the first quarter of 2023 (down 75%), and only $5.3 billion quarter-to-date. The number of sales also plummeted, but not by as much. The number of office properties that changed hands dropped from about 7,300 in the fourth quarter of 2021 to 3,500 in the first quarter of 2023 (down 52%). The geographic mix of office properties explains some of the discrepancy, but also that sellers aren’t yet willing to accept large price cuts. The average price per square foot of office sales was down a mere 6.7% over the same time period, from $330 per square foot to $308. Actual transactions are lagging way behind modeled prices in the space. One example of forward-looking property price indices is produced by Green Street, which imputes prices across investment grade property sectors based on negotiated transactions and REIT net asset values. Their latest commercial property price index (CPPI) report from June 6, 2023, calculates changes in commercial property values through May 2023 (Exhibit 3). This shows office prices down 27% from their recent peak, which was in the second quarter of 2021. While the prices of most other sectors have stabilized month-over-month, office prices fell another 2.7% in May.

Exhibit 3: Green Street CPPI Sector Level Indices

Note: Data through May 2023.
Source: Green Street

Office performance is also differentiated by region, with the tech heavy areas performing worse than the rest of the country. Green Street’s publicly available data doesn’t break down performance by region, but CoStar’s does. Their data shows office property prices were down by 1.9% quarter-over-quarter in the first quarter of 2023 in both the Northeast and West, mostly stable in the South with a small drop of 0.1% and actually rose in the Midwest by 1.9%. These regional discrepancies in office will likely become more pronounced as the maturity wall in office over the next two to three years results in more defaults, distressed sales and a wider wave of re-pricings.

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

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