Chelston Park, Collymore Rock. Photo by Natasha Vlahakis
Capitalization rates (“cap rates”) and discount rates are used the world over in valuing income yielding assets of any asset class, including stocks, bonds and real estate. The rates are derived by calculating a percentage by dividing net earnings by the transaction value of an asset. International valuation standards require that property valuers must rely on capitalized Net Income or EBITDA as the key approach to value for commercial properties.
In sophisticated property markets such as the USA, many of the property sector giants publish rates for each major city and state, by property category. So in the case of a hotel valuation, for example in New York, the valuer may be able to apply rates published by CBRE or JLL specifically for the lodging industry. Those rates would have been derived from a large sample of actual transactions in the previous few months. Realtyrates.com publishes data on all commercial sectors by major urban area in the USA as do Case Schiller. This approach is “evidence based”
We are not so fortunate in Barbados and the Caribbean. There is little transactional evidence on which to calculate cap rates and discount rates. Whilst transaction data is available, financial statements are often not, thereby making it very difficult for the valuer to conclude what multiple the buyer paid for the property. Barbados’ valuers use a range of contacts to ascertain some of the information. Here are a few examples:
- A Bridgetown office building was sold a year or so ago, with an immediate lease to a major commercial bank for a banking hall and executive offices. The lease specified the rent based on the price the purchaser paid.
- Similarly, a few months ago a condo building with sitting tenants in each unit was sold by a receiver. In both instances a “going in” cap rate could be calculated.
These examples are scarce so valuers tend to use the “build up” method by which risk-free rates of returns are ascertained by reference to government paper and premiums are then added for various types of risk. The types of risk taken into account are:
- Country risk – risk which lenders or investors perceive in the country’s economy – Barbados sovereign debt has been subjected to downgrades by Moody’s and Standard & Poors which leads to a lack of investor confidence.
- Currency risk – the risk of a currency devaluation – Barbados currency is linked to the US dollar
- Liquidity risk – property is an inherently illiquid asset class as it cannot usually be liquidated quickly
- Property risk – an assessment of the risks associated with the particular property. Is it in a good location? Is it well maintained?
- Credit or tenancy risk – is it well occupied and are the tenants paying their rent on time?. Would it be in high demand if there was some loss of tenants?
- Operational risk – Is the property well-managed and is the operating strategy sound?
Many of these factors come down to sound investigation and valuer judgment and can raise the level of the cap rate/discount rate significantly. In recent years discount rates of 9.5% to 11% have been the norm.
Recent Trends in the Commercial Property Market
In 2015, the Central Bank abolished the minimum savings rate of 2.5% allowing commercial banks to reduce their deposit rates to less than 1%. Some of the saving in their interest cost has been passed on in reduced lending rates. Almost immediately the typical lending rates quoted by the banks reduced from 8% to around 5.5%. The banks have been able to maintain their spreads whilst making rates more attractive for investment. This has a major impact on discount rates and terminal cap rates, both used in Discounted Cash Flow models for ascertaining the “net present value” of a property. Valuers cannot ignore this dynamic.
The second major impact of the abolition of the MSR is that cash rich investors and institutions are finding it increasingly difficult to find “investment grade” yields of anywhere above 2%. So those investors will return to property with mid to high single digit returns. These investment returns cannot be ignored when a valuer makes a careful assessment on cap rates/discount rates
Above all valuers in Barbados need to recognize that, whilst there are conflicting influences on investment rates, there will be a trend towards purchases of real property with income potential, by cash rich investors who will pay higher prices for good yielding properties and consequently cap rates and discount rates must come down. There is also a recognition that commercial property investments yielding 10% simply don’t exist in today’s market, and that borrowing rates in the mid single digits bring financial gearing back into play for the first time for a decade. The result of the reality is that we expect rates to come down to ranges of 8% to 9%.