Assessors Will Be Challenged to Select Market Adjusted Cap Rates in 2022

Michael Allen, Principal 954.740.6240 |

There are strong opinions both ways in the commercial real estate (CRE) market about cap rate direction. According to a recent Moody’s Analytics report,1 base cap rates will likely rise as interest rates tick up, possibly through next year. Base cap rates are unadjusted for property taxes (by adding the local tax rate) and property-specific risk rates.

While multifamily and industrial have held steady, cap rates in the so-called “lesser-performing” sectors of office, retail, and hotel have reacted to rate hikes. But analysts at Moody’s do expect “some moderate bump” in cap rates across other property types in the near term. Individual investors may disagree, and there is little consensus in how each investor is underwriting deals in this confused marketplace. The Moody’s report suggests there is some room for the risk-free rate to rise before cap rates are pushed to increase. Multifamily, for example, has been aggressively priced with low cap rates: through March 15, about 10% of commercial mortgage-backed security (CMBS) properties had cap rates of 4.5% or lower. They conclude that property types that have been transacting at very low cap rates have little place to go but up.

Tightening monetary policy and the war in Ukraine, which is weighing on energy prices, have increased risk for global markets for the rest of this year, but Moody’s also says that so far, performance metrics on the income side for commercial real estate have been steady. However, they also note that “like single-family home prices responding to higher mortgage rates, we expect that the effect of higher uncertainty will manifest in volatility in CRE prices in the near-term,” the report says.

From a sector-specific viewpoint, Moody’s is maintaining a positive, “robust” outlook for the industrial sector, noting that “the prospects are so strong that industrial lease terms have begun to decline markedly.” The economists note some headwinds, including the news that Amazon will be cutting back on warehouse space, but Moody’s calls that “a drop in the bucket” for the sector and says it’s not likely that third-party logistics providers would scale back significantly. “We expect demand for this property type to remain strong in the near term,” the economists write. “Accordingly, compared to all other core sectors in commercial real estate, our rent growth forecasts for industrial are also the most robust.”

Moody’s says the hotel sector may catch a “much-needed break” if GDP growth remains positive this year, while the office and retail sectors are still catching up. Analysts emphasize, however, the extent to which the tech sector plays a role: those markets with a robust tech presence are showing office rents rising five times faster than the national average. And for retail, neighborhood and community centers are faring better than regional malls, though analysts say slumping consumer sentiment is weighing down the sector’s immediate prospects.

Inflation has finally pushed cap rates in the single tenant net lease sector to increase, with cap rates ticking up by five basis points for retail and by seven basis points for the office sector in the second quarter. Cap rates for single tenant industrial, meanwhile, remained unchanged from Q1, according to the Boulder Group. The recent series of rate hikes by the Federal Reserve and rising inflation led to increased borrowing costs, pushing up cap rates. The June 2022 hike of 75 basis points was the Fed’s largest since 1994, while the 10-year Treasury yield surpassed 3%, hitting 3.5% mid-month. This “created a pause for some net lease investors looking to acquire assets at higher cap rates,” Boulder Group analysts said. Transaction volume in the second quarter of 2022 was down approximately 15% when compared to the same time period in 2021.

Higher-priced properties faced more cap rate pressure, while lower-priced net lease properties saw less impact in pricing, most likely because of more cash purchasers lining up for those deals. CMBS lending remains volatile, but rising rates also constrained loan proceeds and limited loan-to-value. “Transaction activity will remain dependent on the velocity of 1031 buyers motivated by tax consequences and seller’s willingness to move to pricing that meets non-1031 buyer’s return thresholds,” they said, noting that cap rates will likely face continued upward pressure as additional rate hikes materialize this year.

According to a First American Financial Corporation analysis, cap rates might finally start to recover some of their value. The firm’s potential capitalization rate (PCR) model for the first quarter of 2022 estimates capitalization rates based on the historical relationship between interest rates, rental income, prevailing occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends. As the company noted, inflation has stubbornly hung in, rather than being the “transient” phenomenon the Federal Reserve predicted it would be because of pandemic-induced supply chain issues. Eventually the Fed started tightening monetary policy, most recently raising its benchmark interest rates by 75 points, the largest single jump since 1994. One result was a rise in the 10-year Treasury, which went from roughly 1.7% in early January 2022 to a high of 3.48% when the rate hike happened. The 10-year Treasury continues to close around 3%. Given additional expected quantitative tightening—the Fed allows bonds its holding to reach maturity and then removes them from its balance sheet, which eliminates that extra money it had pumped into the system—First American says that the 10-year yield will likely continue to grow.

The 10-year Treasury is seen as a virtually risk-free way of investing and one that investors use to measure the value of riskier investments, including commercial real estate. Another investment will have to now return more to be seen as worth the risk. Since capitalization (cap) rates are a measure of return on an asset, higher “risk-free” rates mean sellers will need to reduce their price expectations or increase cash flow, if that’s an option, to entice buyers seeking competitive yields, which should also push cap rates up.

Currently, cap rates are still at near-record lows, but the PCR model suggests that slower price growth is likely to push cap rates up. But not all CRE property types are in the same position. It is estimated that multifamily and industrial assets will set first-quarter price growth records, increasing at a faster rate than any other first quarter in the past 20 years, while office and retail assets will be a drag on overall CRE price growth in the first quarter. However, a record amount of industrial square footage is currently under construction and expected to come to market later this year, which may slow price growth for industrial assets and put further upward pressure on the potential cap rate as the year progresses.

For most of the last 20 years, the average cap rate across office, industrial, retail, multifamily, hotel, and senior housing has been dropping and is now at a cyclical low as a result of a very low interest rate environment and the limited supply of commercial real estate properties relative to strong post-pandemic demand. In the last quarter of 2021, the actual cap rate hit 5.2%, a record low, but the potential cap was 4.4%. That means property price growth might still top income growth. However, the zero-interest rate regime is officially over. With inflation rising faster than anyone is comfortable with, financing costs go up and buying power recedes.

What does this mean for real property tax assessments and the taxes based upon them in 2022? Despite all indications that cap rates are rising, the answer is probably that proposed CRE assessed values will continue to increase year over year, thereby requiring scrutiny and potential appeals needing to be filed timely to correct inflated values. Assessors just do not react quickly to bad news affecting the CRE market. Although they are typically quick to raise values when cap rates are compressing, they are slow to correct those assumptions as the market conditions turn and cap rates begin to rise.

Furthermore, assessors are under pressure to repair local budgets and tax revenues disrupted and reduced by the pandemic. Many seem to be electing to hesitantly raise proposed assessments and then wait and see which taxpayers are savvy and aware enough to file a timely appeal and present proof of overvaluation using techniques such as the cap rate arguments previously discussed. It is probably fair to say that assessors are generally less certain of their proposed values issued in 2022 than in prior years, and, therefore, appeals are more likely to be successful if well supported by market data.

That is not to say that every proposed assessment will be flawed and justify an appeal. On the contrary, the very confusion in the CRE market that can support a reduction on appeal can cause the unsupported appeal to result in an increase. All appeals must be well supported and, if possible, corroborated by recent arm’s-length sales of like properties and/or an income approach value conclusion using market reconciled assumptions, including tax and risk adjusted cap rates as previously discussed.

The property tax professionals at Ryan are ready to help CRE owners and managers to navigate this complicated and confusing valuation and appeal landscape. We have more than 50 offices in North America staffed with local property tax experts. Please let us know how we can help you better manage and mitigate your property taxes worldwide.

1Sited: Moody’s Analytics report-