In a typical commercial real estate investment, returns come from two sources, income and price appreciation. Income is derived from tenant rental payments and appreciation occurs when market factors increase demand for a property, which makes investors more willing to pay a higher price for a given stream of income.
In this article, we are going to describe the relationship between a property’s price and the income it produces – reflected in the cap rate, what happens when it changes, and how it contributes to commercial real estate price appreciation. By the end readers will be familiar with how cap rates are calculated and the market factors that can potentially cause them to “compress.”
At First National Realty Partners, we perform a significant amount of market research prior to purchase to ensure conditions are optimal for price appreciation. The product of this work is reflected in the deals presented to potential investors. To learn more about our current investment opportunities, click here.
What Are Cap Rates?
In order to understand what cap rate compression is, it is first necessary to understand what cap rates are.
A property’s capitalization rate – cap rate for short – is a performance metric that describes the relationship between a property’s net operating income (NOI) and its market value. The cap rate formula is:
Cap Rate = Net Operating Income / Value
Net operating income is calculated by subtracting a property’s operating expenses from its gross income. Value is obtained from a third party appraisal, an estimate, or the purchase price. The result of this calculation represents an investor’s annual rate of return on the property, assuming it was purchased with cash. For example, if a property had $100,000 in Net Operating Income and a value of $1,000,000, the resulting cap rate is 10%.
For the purpose of this article, another way to think about the cap rate is the price a real estate investor is willing to pay to purchase a stream of income. The price determines what the annual return will be. A lower price for a fixed stream of income means a higher return/higher cap rate. Using the example above, suppose that the NOI remained the same at $100,000, but the price fell to $900,000. The new cap rate is 11.1% ($100,000 / $900,000). Conversely, a higher price for a fixed stream of income means a lower return/lower cap rate. If the price for the $100,000 stream of income rose to $1.25MM, the cap rate falls to 8% ($100,000 / $1,250,000).
The important point is that cap rates are not a static real estate metric. They move up and down in response to market dynamics and their change can have a major impact on the appreciation component of a return.
What is Cap Rate Compression?
Simply, cap rate compression happens when cap rates decline. As described in the example above, falling cap rates imply rising prices for a stream of income. This is an ideal scenario for commercial real estate investors because it results in price appreciation and higher total returns.
So, real estate investors are highly incentivized to find properties in markets that have the highest chance for cap rate compression.
What Causes Cap Rates to Compress?
For any given property, the reasons for cap rate compression can be tough to pin down, but they generally fall into one of two categories, lower risk or increased demand (or both). Potential reasons include the following:
- General Market Conditions: If the general economic conditions in a given market are strong, the risk of purchasing a property decreases and demand for properties in that market rises. Indications of a strong market include: rising population growth, rising wages, low unemployment, and new job creation.
- Leasing Activity: Long term leases to high quality tenants provide investors with a higher degree of certainty that the property’s income stream will be stable. For example, one of the ways that we like to add value to our properties is to leverage our nationwide network of tenant relationships to fill anchor spaces with institutional quality tenants on long term leases.
- Supply and Demand: If market conditions are good and supply is tight, tenants are willing to pay higher rents for good locations. Over the long term, the potential for rising rental income can cause cap rates to compress because investors are willing to pay more for it.
- External Factors: On occasion, something will happen that is totally out of the property owner’s control, but can have a very positive impact on cap rates. For example, and this is common in a place like New York, suppose that an investor owns an apartment building in a location with a difficult commute for residents. But, one day the local government announces plans for a new train stop within walking distance of the property. All of a sudden, the demand for the location could rise, causing compressed cap rates.
- Falling Interest Rates: When interest rates fall, average cap rates tend to compress because the cost of borrowing comes down. This means that investors can afford to pay more for a property.
Regardless of the cause, cap rate compression is a good thing for real estate investors because it causes asset values to rise, which in turn leads to a higher return on investment.
How Impactful is Cap Rate Compression?
To demonstrate how impactful cap rate compression is in commercial real estate, let’s continue the example from above with a multifamily property that produces $100,000 in NOI and has a value of $1MM, producing a 10% cap rate at the time of purchase. But, over the course of several years, the owner has signed tenants to new long term leases and completed renovations to bring the property up to modern standards. As a result of all of this activity, the prevailing market cap rates have fallen to 7.5%. With this information, the cap rate calculation can be rearranged to calculate the new value:
Market Value = Net Operating Income / Market Cap Rate
Using this logic, the property’s new value is $1.33MM ($100,000 / 7.5%), which represents price appreciation of 30%. But, let’s go a step further. In the scenario above, NOI stays the same over time while the cap rate changes, but this is rarely the case. In an ideal scenario, NOI goes up and cap rates go down. Let’s now assume that, as a result of the owner’s work, NOI rises to $125,000 and cap rates fall to 7.5%. The new value is $1.66MM, a 60% increase. This is the holy grail for real estate investment.
Summary & Conclusion
A property’s cap rate is a performance metric that describes the relationship between net operating income and the value of the property.
Cap rates are not static, they rise and fall in response to changing market conditions. Cap rate compression occurs when cap rates decline. When they do, valuations rise which is a positive for investors.
Cap rates can fall for a variety of reasons, including real estate market conditions, supply and demand, leasing activity, and from external factors. No matter the cause, a falling cap rate causes property values to appreciate, which is a good thing for investors.
In an ideal situation, real estate property cap rates compress at the same time net operating income rises. When this happens, rental property appreciation can be dramatic, which can lead to strong overall returns.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.