How to Determine a Fair Cap Rate for Class B Office Buildings in Declining Markets?

As an acquisitions officer, you’re caught between the pressure to deploy capital and the terror of catching a falling knife. The Class B office market is a minefield of value traps, and every broker is pitching a “once-in-a-generation” opportunity. The standard advice is uselessly simplistic: “look at sales comps,” “add a risk premium.” This is the language of bull markets, and applying it now is professional malpractice. In a declining market, there is no “fair” cap rate; there is only a defensible one.

Your job is not to find a number that feels right. It is to construct a valuation so rigorously stress-tested and grounded in pessimistic data that it can withstand the intense scrutiny of an investment committee that assumes you are wrong. This requires a shift in mindset from valuation to forensic risk mitigation. You must deconstruct flawed comps, challenge every optimistic assumption, and understand that the most important variable—the exit cap rate—is a fantasy you must aggressively discount.

This is not a guide for finding the market rate. This is a framework for building a defensive position. We will dissect the metrics that actually matter, dismantle the fallacies that lead to overpayment, and turn the market’s distress into your primary negotiation tool. Forget what the seller’s proforma says. The real story is in the data they hope you’ll ignore.

This article provides a structured methodology to build a defensible valuation for Class B office assets in today’s treacherous market. The following sections will guide you through the critical components of this forensic approach.

Why the Spread Between Cap Rates and Treasury Yields Matters More Than the Rate Itself?

Stop focusing on the absolute cap rate. In a volatile environment, a 7% cap rate can be a bargain or a trap, and the number itself tells you nothing. The only metric that provides context for risk is the cap rate spread: the difference between your property’s cap rate and the risk-free rate, typically the 10-Year Treasury yield. This spread is the compensation you demand for taking on the myriad risks of commercial real estate—illiquidity, credit loss, and obsolescence—over holding a government bond.

In a declining market, an investor’s focus must be on whether this spread is adequately widening to compensate for increasing risk. A narrowing spread in a down market is a clear signal of overpricing. The sensitivity of this spread varies significantly by asset class, which is a critical point of analysis. For instance, CBRE research shows that for every 100-basis-point change in the 10-year Treasury yield, office cap rates move 70 bps, whereas more resilient industrial properties move only 41 bps. This demonstrates the higher perceived risk and volatility inherent in the office sector today.

History provides a crucial, if counter-intuitive, lesson. During the high-interest-rate Volcker era of the 1980s, cap rate spreads were often negative, averaging -2.8%. Yet, even in that environment, multifamily properties appreciated 5.7% annually. This proves that a wide spread during a downturn, while indicating high current risk, can also signal a significant buying opportunity for investors who correctly underwrite future growth and are not simply reacting to current interest rates.

Therefore, your analysis must begin and end with the spread. A historical analysis of the spread for Class B office in your specific submarket is non-negotiable. If you cannot prove you are being paid an adequate, historically justified premium for the risk you are taking, the absolute cap rate is a meaningless and dangerous distraction.

How to Derive a Market Cap Rate From Sale Comps That Hide NOI Data?

In a declining market, “comparable” sales are rarely comparable. Brokers will present comps with attractive sale prices per square foot, but conveniently, the Net Operating Income (NOI) is almost always missing. This is intentional. The lack of NOI data obscures below-market occupancy, exorbitant concessions, and unsustainable rental rates. Relying on these sales for a direct cap rate is a recipe for disaster. Your task is to perform a forensic analysis to reverse-engineer a defensible cap rate from this flawed data.

This process is about making explicit, data-driven adjustments. You are not trying to find the seller’s implied cap rate; you are constructing a stabilized cap rate for a truly comparable, albeit hypothetical, property. This means adjusting for every material difference between the comp and your target asset. You must build a matrix of adjustments based on market realities, not broker narratives.

The following table provides a framework for these adjustments. These are not suggestions; they are mandatory starting points for your underwriting. Each adjustment must be documented and defended with submarket data on vacancy, age of competing stock, and lease term trends.

By applying these adjustments, you move from a misleading “market” cap rate to a defensible, risk-adjusted cap rate. If a comp sold at what appears to be a 7% cap rate but had 95% occupancy with long-term leases, while your target has 75% occupancy and near-term rollover, your adjusted entry cap rate for analysis must be significantly higher, perhaps 8.5% or more. Without this forensic work, you are simply adopting the seller’s fiction.

Entry Cap Rate vs. Exit Cap Rate: Which Assumption Drives Your IRR?

The entry cap rate is a fact, determined by your purchase price. The exit cap rate is a fantasy. Yet, it is this fantasy that has the single greatest impact on your projected Internal Rate of Return (IRR). In a declining market, the most common and destructive mistake is underwriting an exit cap rate that is flat or, worse, compressed relative to your entry rate. This “assumption velocity”—the dangerous speed at which a flawed exit cap assumption inflates returns—is the primary cause of capital destruction in down cycles.

Your model is worthless if its success hinges on a favorable exit. The only responsible approach is to stress-test the exit cap rate to its breaking point. You must determine the maximum possible exit cap rate your deal can withstand while still meeting your minimum required IRR. This isn’t a forecast; it’s a structural integrity test. If your deal only works with 50 basis points of exit cap expansion but the market is showing signs of 200 bps of potential expansion, your deal is broken.

Consider the ‘doomsday’ scenarios being modeled for major markets. For instance, in a severe scenario, New York City’s Department of Finance calculated that Manhattan office valuations could see a cumulative drop in value of about 17% by FY 2027. This level of decline implies significant cap rate expansion that must be factored into any realistic exit scenario. Your underwriting must reflect this pessimistic reality, not a hopeful recovery.

The following audit is not optional. It is the core process for neutralizing the risk of a fantasy-based exit assumption and ensuring your IRR is grounded in reality.

The Cap Rate Compression Fallacy That Ruins Long-Term Investment Returns

The siren song of cap rate compression has shipwrecked countless investment theses. The narrative is seductive: buy a Class B asset, invest some capital, raise the NOI, and sell at a lower cap rate to a less sophisticated buyer. This strategy is a relic of a zero-interest-rate environment. In a declining, structurally impaired office market, underwriting any level of cap rate compression is not just optimistic; it is a dereliction of fiduciary duty.

The market is signaling a long-term, secular repricing of risk, particularly for secondary assets. As the expert analysis from Capital Economics bluntly states, “office values are only partly through their decline.” They project that a significant price plunge is still ahead, and it may take two decades or more for values to regain their pre-2020 peaks.

Office buildings still have another 20% price plunge ahead, with the overall peak-to-trough decline for US office values reaching 43%, and it will likely take two decades or more before they regain their early-2020 peak.

– Capital Economics, Capital Economics Research Report

This is not a cyclical dip; it’s a fundamental reset. Furthermore, the idea of a “flight to quality” protecting all assets is a dangerous oversimplification. Recent data reveals a surprising trend: in 2024, the value of premium Class A or A+ properties decreased by a staggering 22%, while Class B properties slipped a comparatively modest 3% year-over-year. This doesn’t mean Class B is “safer”—it means the pain has been disproportionately felt at the top so far, and the repricing for secondary assets may have a longer, more painful road ahead as tenants with expiring leases continue to seek quality at a discount.

Your default assumption must be significant cap rate expansion over your hold period. How much? At least 100-150 basis points. Anything less is a bet against the overwhelming tide of market data and expert consensus. Basing your returns on the hope of cap rate compression is not investing; it’s gambling with other people’s money.

How to Use Cap Rate Expansion to Negotiate a Lower Purchase Price?

Every piece of negative market data is a tool for negotiation. The expectation of cap rate expansion is not just a risk to be modeled; it is your single most powerful piece of leverage to drive down the purchase price. The seller’s initial asking price is anchored in a past market. Your job is to re-anchor the negotiation in the brutal reality of the present and the pessimistic outlook for the future.

You must assemble a data-driven negotiation dossier that systematically dismantles the seller’s optimistic pricing. This is not about arguing; it is about presenting irrefutable evidence. Your dossier must include a sensitivity analysis showing the devastating impact of 100, 150, and 200 basis points of exit cap rate expansion on the asset’s valuation. This transforms a theoretical risk into a concrete dollar amount that you are not willing to pay.

Your case is further strengthened by concrete examples of market distress. Pointing to high-profile losses makes the risk tangible. This is not about being antagonistic; it is about being realistic about the price at which capital is actually trading for similar assets today.

When you present a lower offer, it cannot be arbitrary. It must be the direct output of your defensive underwriting. Your offer is not “low”; it is the price required to achieve a minimum acceptable return, assuming significant cap rate expansion at exit. By tying your offer directly to this pessimistic-but-defensible model, you shift the negotiation from a debate over price to a discussion about risk and future market realities.

Why Increasing Your Discount Rate by 1% Can Drop Asset Value by 20%?

While cap rates are crucial for entry and exit valuation, the discount rate used in your Discounted Cash Flow (DCF) analysis determines the present value of all future cash flows. It is the engine of your valuation model, and its sensitivity is extreme. In a stable market, analysts might argue over 25 or 50 basis points. In a declining market, underestimating the appropriate discount rate by even a small margin can lead to a catastrophic overestimation of value.

The discount rate is a reflection of both the time value of money and, more importantly, the perceived risk of achieving the projected cash flows. As market risk escalates, your discount rate must escalate accordingly. The impact of this adjustment is not linear; it is exponential. This is particularly true for Class B assets, which are perceived as having less durable income streams than their Class A counterparts.

The following table illustrates the brutal mathematics of this reality. A modest increase in the discount rate, reflecting rising market risk, has a disproportionately negative impact on the valuation of a Class B asset. This is a mathematical certainty your underwriting cannot ignore.

As the data shows, a mere 100-basis-point increase in the discount rate—a completely plausible adjustment in today’s market—can wipe out over 20% of a Class B asset’s perceived value. If your analysis is based on a discount rate from 12 or 24 months ago, it is already obsolete and dangerously wrong. You must re-evaluate and justify your discount rate based on current capital market conditions and the rising tide of distress, evidenced by metrics like CMBS delinquency rates.

Your investment committee will challenge this assumption relentlessly, and for good reason. Justifying your discount rate is as critical as justifying your exit cap rate. It must be benchmarked against current lending standards, public REIT implied rates, and the observable risk in the market.

Variable vs. Fixed Rates: Which Has Historically Cost Less Over 20 Years?

The debate over variable versus fixed-rate debt is academic in a stable market. For a Class B office building in a declining market with an uncertain NOI future, it is a matter of survival. The historical performance of variable rates is irrelevant. Your analysis must focus on one thing: eliminating risk. Opting for variable-rate debt on a transitional asset in this environment is not a calculated risk; it is an unforced error.

A floating rate exposes your proforma to the whims of the Federal Reserve and the capital markets. Any projected cash flow can be wiped out by a spike in the Secured Overnight Financing Rate (SOFR) or a widening of lender spreads. Hedging strategies like interest rate caps add cost and complexity, and they only provide temporary protection. The fundamental risk remains: your cost of capital is not within your control.

For a Class B office with uncertain future NOI, eliminating interest rate risk is not a cost but a form of insurance that is essential for survival.

– Commercial Real Estate Finance Expert, Industry Analysis on Distressed Asset Financing

Securing long-term, fixed-rate debt is the only prudent course of action. It transforms an unknown variable into a known constant, allowing you to underwrite your cash flows with a degree of certainty. This certainty is worth paying a premium for. If the deal does not “pencil” with fixed-rate debt, the deal is broken. Attempting to make it work by gambling on a lower, variable rate is a failure of discipline.

Furthermore, your underwriting must aggressively model refinancing risk. What happens at the end of your loan term? Assuming you can easily refinance based on your “stabilized” future value is naive. Lenders will underwrite your asset based on the market conditions at that future date, which are likely to be more conservative. You must build reserves for a potential “cash-in” refinancing, where the lender’s new, lower valuation requires you to contribute equity to meet their loan-to-value (LTV) requirements. Failure to model this is a critical oversight.

How to Conduct a Comparable Market Analysis for Unique Commercial Properties?

In a market with collapsing transaction velocity, finding a “perfect” comp is impossible. The data pool is thin, and every asset has a story that makes it unique. A traditional Comparable Market Analysis (CMA) is insufficient. You need a three-tiered forensic analysis that triangulates value from different, often imperfect, data sources. This method builds a defensible valuation not on a single set of comps, but on a convergence of evidence.

First, analyze the public markets. The public Real Estate Investment Trusts (REITs) are a live, real-time barometer of investor sentiment for office assets. As of late 2023, Green Street reported that the largest public office REITs were trading at an average discount of -45% to their own stated Net Asset Value (NAV). This public market discount is a powerful indicator of where sophisticated capital values the sector, and it provides a critical benchmark for your own private market valuation.

Second, expand your definition of “comp” to include distressed situations. This includes assets sold out of foreclosure, short sales, and note sales. These are not outliers to be dismissed; in a declining market, they are the leading indicators of true market-clearing prices. While these sales require significant adjustment for condition and circumstance, they provide a floor for your valuation that is grounded in the reality of forced liquidation.

Finally, analyze the “comps of the comps.” This means digging into the leasing data of buildings that are competing with your target asset for tenants right now. What are the net effective rents after accounting for a year of free rent and massive tenant improvement allowances? What is the velocity of leasing? This data allows you to build a forward-looking DCF based on the real cost of attracting tenants today, not on the rosy, in-place rent roll that may not be replicable. This approach provides a bottom-up valuation to complement the top-down comps.

The market does not reward hope. The only path to success in this environment is through rigorous, skeptical, and defensive underwriting. Begin applying this forensic framework to your next acquisition analysis and protect your capital from predictable losses.