The capitalization rate, “cap rate” for short, is a commercial real estate return metric that provides investors with information about the relationship between a property’s net operating income (NOI) and its value. From a mathematical standpoint, the cap rate represents an investor’s annual rate of return, assuming that the property was purchased with cash. Cap rate is typically calculated as part of the pre-purchase due diligence process. However, cap rates are not static; they change over time in response to market conditions.
In this article, FNRP discusses the ways that cap rates can change and what can drive these changes. By the end, readers will have a better feel for what causes changes in the cap rate and how those changes impact property values and real estate investment returns.
At First National Realty Partners, we pay close attention to cap rates both before making a purchase and as part of our ongoing risk management program. In doing so, we are able to provide investors with best in class investment opportunities. To learn more about them, click here.
Meaning of Cap Rate Expansion
In the cap rate definition above, there is a key point that is helpful in understanding cap rate expansion. Fundamentally, the cap rate is a measure of return. And, as all real estate investors know, there is a strong relationship between the return offered by a property and the risk of achieving it. With this in mind, the phrase “cap rate expansion” is simply another way of saying that cap rates are going up or rising.
What Causes Cap Rates to Rise?
An expansion in cap rates is simply the market’s way of saying that the risk of purchasing commercial real estate assets is rising. The reasons for expanding cap rates are numerous and complex, but they could include things like:
- Rising Interest Rates: As a general rule of thumb, cap rates tend to go up when interest rates rise. This movement reflects the increased cost of borrowing, which means that returns also need to rise in order to maintain the same level of profitability. To achieve higher returns, property prices have to fall.
- Excessive Supply: If the market is flooded with excessive supply, it would be normal for rental rates to fall in response. Falling rental rates increase the risk associated with a property so returns need to rise to compensate investors for the increased risk.
- Macroeconomic Conditions: If the outlook for the economy in general is poor, cap rates tend to rise. In particular, certain data points like job growth, wage growth, unemployment, and inflation, are strong predictors of deteriorating economic conditions. Any type of economic uncertainty increases risk, which causes cap rates to rise.
It should be noted that these reasons have more to do with the market than the property itself. But, cap rates can expand for a specific property as well. Again, the reasons why could be numerous and complex, but they are all related to the perceived risk increasing. For example, the property could age, a lease for a major tenant could be expiring soon, or the property could have a tenant that has recently declared bankruptcy.
To illustrate how cap rates can change in response to market conditions, look at the blue line in the chart below. This is a graph of cap rates for US multifamily assets from 2002 – 2018:
Source: Berkadia, “A Retrospective Look at a Historic Cycle in Commercial Real Estate
Moving from left to right in the chart, it can be seen that cap rates fell steadily from 2002-2006 (prices were rising), which corresponds strongly to the economic expansion during the same time period. But, rates level off and then begin to rise substantially from 2007 – 2010 (prices falling) which corresponds to the great recession and its immediate aftermath. Then, as the longest peacetime economic expansion begins in the ~2010 period, rates fall gradually until 2018.
The bottom line is this, when market and/or property level conditions are poor or uncertain, cap rates tend to expand, which results in falling property prices.
Meaning of Cap Rate Compression
Cap rate compression is the opposite of expansion, it is when cap rates fall. Lower cap rates mean higher property prices, which is a positive for real estate investors because higher property valuations are correlated with higher returns.
What Causes Cap Rates to Fall?
In real estate investment, cap rates compress for the opposite of the reasons they expand:
- Falling Interest Rates: When interest rates fall, the cost of borrowing for real estate investors also falls. This means higher cash flows after debt service and investors are willing to pay more for this. Lower cap rates equals higher property prices.
- Limited Supply: The basic laws of supply and demand dictate that prices rise when there is limited supply. This is particularly true when limited supply is coupled with high commercial property demand. This scenario is a perfect storm for rising prices, which means falling cap rates.
- Macroeconomic Conditions: When economic conditions are good, investors feel more confident about the future and are willing to pay higher prices / accept lower returns for the opportunity to participate in a strong market. Hallmarks of a strong economy are data points like: falling unemployment, falling interest rates, rising job growth, and rising wages.
Again, compressed cap rates can happen at the broader macroeconomic level – as described above – or they can happen at the property level. Scenarios that would cause cap rate compression at the property level include things like: strong data points in the local real estate market (e.g. rising rental rates), increased occupancy, addition of a major tenant on a very long term lease, or the completion of a major renovation.
With this information in mind, take another look at the same chart above:
Source: Berkadia, “A Retrospective Look at a Historic Cycle in Commercial Real Estate
Cap rate compression, meaning that the average cap rate is falling, can be seen from 2002 – 2006 and from 2010 – 2018. At a macroeconomic level, both of these periods correspond to periods of strong growth and rising returns.
Why It Is Important To Understand Cap Rate Compression vs. Expansion
Regardless of the asset class, commercial real estate investing returns typically have two components, income and appreciation. Income is reasonably predictable because it is driven by leases and known operating expenses. Income tends to be slow and steady.
Appreciation is a bit less predictable. It is tied to changes in both the local market and/or the broader economy. Investors may spend a significant amount of time trying to predict which markets will perform well, but they aren’t always right. So, it is necessary to understand how and why cap rates expand and contract in response to market conditions in order to understand how asset values have the potential to change.
The goal for every investment property is to have increasing income and capital appreciation. When this is the case, potential real estate returns are optimized and everyone is happy.
Summary & Conclusion
- The cap rate is a real estate performance metric that describes the relationship between a property’s net operating income and its market value. It represents the expected annual rate of return if the property was purchased with cash.
- Cap rates are not static. They expand and contract in response to market conditions
- Cap rate expansion – higher cap rates- happens when market conditions are poor or uncertain and generally leads to falling property prices.
- Cap rate compression – lower cap rates – is the opposite. It happens when market conditions are strong and generally leads to rising real estate values.
- When underwriting a property, it is important to understand the difference between cap rate expansion and compression, and what causes both, to understand how returns will be impacted.
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 info@fnrpusa.com for more information.
