Cap Rates Are Low. What Does That Mean For Your Gas Station?
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Capitalization rates (cap rates) on commercial real estate have been trending downward for several years, causing significant appreciation in real estate asset values. This is creating an interesting opportunity for real estate-owning convenience store and gas station operators to potentially monetize these enhanced real estate valuations.
What Are Cap Rates?
To capitalize on this opportunity, it’s helpful to understand how commercial real estate investment professionals analyze, value and price real estate assets. The most common measure is the cap rate. Cap rates are the rate of expected annual return on a real estate investment property (similar to bond yields in the fixed income market). A cap rate is calculated by taking the annual net operating income (NOI) of a property divided by assets market value (see below).
The formula above can be adjusted to determine asset values by dividing NOI by the cap rate (commonly called “Capping NOI”).
As you can see from the formula above, as cap rates decrease, values increase (as investors are willing to accept a lower rate of return on their initial investment). Since cap rates have been decreasing over the last several years, this has been one of the drivers of higher real estate asset prices.
Cap rates typically compress during periods of declining interest rates, and the recent prolonged period of lower rates has helped keep cap rates down. But they’re also driven by supply and demand and risk-return considerations. A lot of investment capital is currently flowing into the convenience and gas station industry, which is also helping to keep cap rates low.
Retail Cap Rate Trends
Cap rates have been decreasing for several years, giving rise to increase asset values. Making predictions on where cap rates will move prospectively is a complicated and tricky analysis involving everything from interest rate movements, investor sentiment, the performance of the economy and even global political events. In general, however, cap rates tend to rise during recessionary periods or times of global uncertainty. If the real estate outlook turns negative, market pricing may adjust downward, causing cap rates to rise as well. Convenience and gas station property owners considering monetizing the relatively rich property valuations while investors remain bullish on the industry could be at risk of missing an opportunity if they wait too long.
One of the key drivers of cap rates is the long-term Treasury rate. Typically, cap rates are set at a spread premium to the 10-year U.S. Treasury. As Treasury yields drops, cap rates typically drop in step. It’s important to pay attention to this spread. If the spread begins to narrow, that may be a signal of a real estate asset valuation bubble; the risk being that cap rates will increase as they revert to their long-term spread against the Treasury, and real estate valuations will contract.
The current 10-year Treasury note continues to experience volatility, especially over the second half of 2019. Through 2019 as a whole, the 10-year yield fell by 77 basis points, ending the year at 1.92%. The decline is mostly attributed to the escalation of trade tensions, which increased in August. As for January 2020, yields continue to fluctuate based on U.S.-China relations and the recent geopolitical concerns with Iran. U.S. investors are trying to gauge the possibility of a larger conflict between both sides while also maintaining increased confidence of a phase two trade deal with China. BMO’s economists project 10-year Treasuries may creep up through the first quarter of 2020 and continue to drift up slightly through the remainder of the year.1
As for recent c-store cap rates, they remain resilient and compressed by an additional 20 basis points in the third quarter of 2019, likely due to the strength of the industry and the decline of the 10-year Treasury yield. However, we should not expect that trend to continue indefinitely. As discussed, there are numerous factors that drive cap rates, and cap rates for single-tenant commercial properties overall actually increased by nearly 16 basis points during the same period.2
What it Means to Operators
Lower cap rates present the potential for meaningful monetization opportunities for operators with fee simple property. Some operators may be able to partially monetize their ownership by divesting the real estate in a sale-leaseback transaction.
In a sale-leaseback, the operator sells the real estate to an investor and concurrently executes a long-term lease on the property. The value of that property is driven by the agreed upon rent and cap rate. In these cases, multiple factors determine the cap rate, including credit quality, lease terms, property size and location.
The benefit of a sale-leaseback is that it allows the operator to continue to own the business and receive income derived from operations while monetizing the real estate. The transaction essentially separates the value of the business from the value of the real estate. The alternative mechanism for unlocking the real estate value is through a full sale of the business. Operators who are not ready to sell can use the sale-leaseback to partially monetize their ownership, taking advantage of near all-time low cap rates.
Today’s historically high M&A multiples are partially being fueled by the low cap rates. Buyers who want to own the real estate are required to “lean in” on the purchase multiple.
Furthermore, the escalated real estate values contribute to enhanced financing options:
- Banks may get more comfortable increasing leverage through higher real estate values and, therefore, lower loan-to-value ratios.
- Buyers may choose to concurrently execute a sale-leaseback, providing proceeds to fund an acquisition, reducing the equity or debt required.
Where are we headed?
It’s difficult to predict how valuation multiples and cap rates will move in 2020.The general consensus, however, is that cap rates and their spread against Treasuries have been compressing for some time, creating increased real estate asset values. In many markets, real estate asset values are higher today than they were before the financial crisis.
For now, industry investors remain optimistic; c-stores are considered resistant to e-commerce competition and in the event of an economic slowdown, gas stations are considered inelastic. In other words, enjoy the positive industry trends and enhanced valuations partially fueled by compressed cap rates.
Jonathan Graham
Vice President | Fuel Services
Capitalization rates (cap rates) on commercial real estate have been trending downward for several years, causing significant appreciation in real estate asset values. This is creating an interesting opportunity for real estate-owning convenience store and gas station operators to potentially monetize these enhanced real estate valuations.
What Are Cap Rates?
To capitalize on this opportunity, it’s helpful to understand how commercial real estate investment professionals analyze, value and price real estate assets. The most common measure is the cap rate. Cap rates are the rate of expected annual return on a real estate investment property (similar to bond yields in the fixed income market). A cap rate is calculated by taking the annual net operating income (NOI) of a property divided by assets market value (see below).
The formula above can be adjusted to determine asset values by dividing NOI by the cap rate (commonly called “Capping NOI”).
As you can see from the formula above, as cap rates decrease, values increase (as investors are willing to accept a lower rate of return on their initial investment). Since cap rates have been decreasing over the last several years, this has been one of the drivers of higher real estate asset prices.
Cap rates typically compress during periods of declining interest rates, and the recent prolonged period of lower rates has helped keep cap rates down. But they’re also driven by supply and demand and risk-return considerations. A lot of investment capital is currently flowing into the convenience and gas station industry, which is also helping to keep cap rates low.
Retail Cap Rate Trends
Cap rates have been decreasing for several years, giving rise to increase asset values. Making predictions on where cap rates will move prospectively is a complicated and tricky analysis involving everything from interest rate movements, investor sentiment, the performance of the economy and even global political events. In general, however, cap rates tend to rise during recessionary periods or times of global uncertainty. If the real estate outlook turns negative, market pricing may adjust downward, causing cap rates to rise as well. Convenience and gas station property owners considering monetizing the relatively rich property valuations while investors remain bullish on the industry could be at risk of missing an opportunity if they wait too long.
One of the key drivers of cap rates is the long-term Treasury rate. Typically, cap rates are set at a spread premium to the 10-year U.S. Treasury. As Treasury yields drops, cap rates typically drop in step. It’s important to pay attention to this spread. If the spread begins to narrow, that may be a signal of a real estate asset valuation bubble; the risk being that cap rates will increase as they revert to their long-term spread against the Treasury, and real estate valuations will contract.
The current 10-year Treasury note continues to experience volatility, especially over the second half of 2019. Through 2019 as a whole, the 10-year yield fell by 77 basis points, ending the year at 1.92%. The decline is mostly attributed to the escalation of trade tensions, which increased in August. As for January 2020, yields continue to fluctuate based on U.S.-China relations and the recent geopolitical concerns with Iran. U.S. investors are trying to gauge the possibility of a larger conflict between both sides while also maintaining increased confidence of a phase two trade deal with China. BMO’s economists project 10-year Treasuries may creep up through the first quarter of 2020 and continue to drift up slightly through the remainder of the year.1
As for recent c-store cap rates, they remain resilient and compressed by an additional 20 basis points in the third quarter of 2019, likely due to the strength of the industry and the decline of the 10-year Treasury yield. However, we should not expect that trend to continue indefinitely. As discussed, there are numerous factors that drive cap rates, and cap rates for single-tenant commercial properties overall actually increased by nearly 16 basis points during the same period.2
What it Means to Operators
Lower cap rates present the potential for meaningful monetization opportunities for operators with fee simple property. Some operators may be able to partially monetize their ownership by divesting the real estate in a sale-leaseback transaction.
In a sale-leaseback, the operator sells the real estate to an investor and concurrently executes a long-term lease on the property. The value of that property is driven by the agreed upon rent and cap rate. In these cases, multiple factors determine the cap rate, including credit quality, lease terms, property size and location.
The benefit of a sale-leaseback is that it allows the operator to continue to own the business and receive income derived from operations while monetizing the real estate. The transaction essentially separates the value of the business from the value of the real estate. The alternative mechanism for unlocking the real estate value is through a full sale of the business. Operators who are not ready to sell can use the sale-leaseback to partially monetize their ownership, taking advantage of near all-time low cap rates.
Today’s historically high M&A multiples are partially being fueled by the low cap rates. Buyers who want to own the real estate are required to “lean in” on the purchase multiple.
Furthermore, the escalated real estate values contribute to enhanced financing options:
- Banks may get more comfortable increasing leverage through higher real estate values and, therefore, lower loan-to-value ratios.
- Buyers may choose to concurrently execute a sale-leaseback, providing proceeds to fund an acquisition, reducing the equity or debt required.
Where are we headed?
It’s difficult to predict how valuation multiples and cap rates will move in 2020.The general consensus, however, is that cap rates and their spread against Treasuries have been compressing for some time, creating increased real estate asset values. In many markets, real estate asset values are higher today than they were before the financial crisis.
For now, industry investors remain optimistic; c-stores are considered resistant to e-commerce competition and in the event of an economic slowdown, gas stations are considered inelastic. In other words, enjoy the positive industry trends and enhanced valuations partially fueled by compressed cap rates.
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