Uncovering the Value of Mid-America’s Commercial Real Estate

To grasp the reason behind the attractive valuation of commercial property in the heartland of America, one should begin with the basics of real estate investment. The worth of a property is derived from the quantum and schedule of cash inflows it will yield, along with the risk associated with realizing those cash inflows. These elements are usually simplified into two metrics: the Net Operating Income (NOI) and the capitalization rate, or cap rate.

In most scenarios, a property’s cash inflows are dictated by the rental rate that can be levied. From a tenant’s viewpoint, the rent they pay is regulated by their potential earnings from using the specific property. The aggregate of rental payments collected by the property owner, after accounting for any expenses related to the property, results in the NOI. Essentially, NOI represents the disposable cash that a property produces, which can be directed towards servicing loan repayments, reinvesting into the property, or distributing to investors.

When assessing two properties that are physically identical and offer the same level of usefulness to tenants, it’s reasonable to expect their rental income and net operating income (NOI) to align. However, a significant disparity in their overall valuation might occur if the determinants of the capitalization rate diverge.

Consider the following chart of the top US industrial markets in December 2023:

The logic behind industrial properties located near substantial coastal population hubs being more beneficial for tenants compared than those in smaller cities like Cincinnati, Columbus, Indianapolis, or Kansas City is understandable. However, what about the comparison to Dallas or Atlanta? Is it really accurate to say that properties in the Bay Area, New York City, and Southern California provide tenants with double or even triple the benefits compared to those in significant mid-American markets?

Assuming that the tenant value across these markets accurately corresponds with their respective rental rates, the capitalization rate or cap rate still needs to be factored into the equation. One would expect that investors in markets where rental prices are already nearer the peak of tenant utility would take this into account when determining their cap rate variables. Surprisingly, this is not the case. On the contrary, repeated surveys indicate that the cap rate for industrial properties in coastal markets is 150 to 200 basis points lower than those in the country’s heartland. This implies that investors are willing to pay 26 times a property’s annual earnings in a coastal market, compared to only 18 times for a similar property in a heartland market.

For those who are confident in the renaissance narrative of middle America, the prospect is obvious. Why would any investor choose to spend extra to invest in economies grappling with financial challenges when there are opportunities to invest in heartland economies with stronger prospects at more appealing valuations?

Stay tuned for the final part of this series where we discuss the challenges that Middle American investments can bring and how Tempus bridges the gap.

Dan Andrews
CEO