Decoding Cap Rates

October 30, 2013

All cap rates are not created equal. Hot areas like Los Angeles and San Francisco are going to elicit different numbers than a secondary market such as Denver or Phoenix. We can all agree on this, but what exactly are the differences in spread amongst these markets? And how are they determined?

Let’s take a Class A industrial property in a Class A market as an example benchmark. We interviewed investors and other market participants, and then asked them to consider the same exact asset in alternate locations.

Hypothetical Industrial Building: Single Tenant, 250,000 square foot, NNN-leased, 32’ clear; ESFR sprinklered; 10-year or longer remaining lease term, at market rent, annual escalations in lease.


Inland Empire   4.75% to 5%

Bay Area   4.75% to 5%

Seattle (Kent Valley)   5% to 5.25%

Denver   5.75% to 6.5%

Phoenix   6.5% to 7.0%

Differential – Lowest to Highest   225 bps

Source: Market Participant Interviews and Sale and Listing Transactions

So why did our game of fantasy cap rate yield different results from one market to another? There is both a why and a how to this answer.

How are these different cap rates generated?

Take a look at the investor buying parameters for Primary and Secondary Markets from the most recent Colliers Western US Industrial Overview.

Primary Markets

  • Rent Growth: “Inflationary Plus” (25% – 30% over first five years); back to peak
  • Retention: 65% – 80%
  • Time to Stabilization: 4 – 6 Months
  • Exit Value: Adjusted to NOT exceed inflated replacement cost
  • Basis Value to Replacement Cost: 100% – 110%

Secondary Markets

  • Rent Growth: “Inflationary” (15% – 20% over first five years); may not achieve prior peak
  • Retention: 50% – 70%
  • Time to Stabilization: 9 – 18 Months
  • Exit Value: Adjusted to be at a discount to inflated replacement cost and to NOT exceed a 2% – 3% Compound Annual Growth Rate
  • Basis Value to Replacement Cost: 75% – 90%

In Primary markets, higher projected rent escalations, lower turnover costs, higher exit value projections and shorter stabilization periods allow investors to pay more for properties, resulting in lower capitalization rates. For Primary markets, investors were willing to pay 100% to 110%, and for secondary markets 75% to 90% of replacement cost.

Why are different cap rates generated?

Investors are willing to have more aggressive assumptions in primary markets because of that tried and true economic axiom: supply and demand.

Supply: Primary markets are perceived as having constraints to new development, typically less available land for new construction. This creates supply constraints protecting the market for existing product. For multifamily, industrial, retail and office a supply constraint story will provide investors a better rationale to risk capital allowing them to be more aggressive.

Demand: Investment properties require tenants to generate cash flow. In primary markets there is higher confidence among investors of tenant demand for good quality product. This perception was well supported in multiple studies over the recent economic downturn. Primary markets are diverse economies with strong fundamentals and international recognition from investors. Additionally, investors are concerned about exit strategy, and primary markets have a higher volume of transactions than secondary markets. Of note, Colliers Investor Services Group tracked 13 major transactions in the Western United States from January 2013 to June 2013. Ten were in Southern California markets, two in Las Vegas/Phoenix, and one was in the Pacific Northwest.

Please contact us to learn more about cap rates and how we can help you finance your next property.