Jan 11, 2023

The Role of Cap Rates in Real Estate

written by Tom Ethington

Cap rates, or capitalization rates, are a key metric used in the real estate industry to evaluate the potential initial cash return on an investment of a property. Essentially, a cap rate represents the annual return on the real estate investment that an investor should expect to receive, based on the net operating income it generates without utilizing debt.

How to determine a cap rate

The cap rate formula is calculated by dividing the annual net operating income (NOI) of a property by the price paid. It is expressed as a percentage and is often used to compare the relative cash return of different properties.

annual net operating income (NOI) / the property price paid = cap rate

Understanding cap rates in real estate

In real estate investing, the cap rate is an important metric to consider when evaluating potential investments. A higher cap rate means a higher initial return on investment, while a lower cap rate means a lower initial return on an investment. However, the lower the cap rate, the lower the perceived risk of the real estate investment. While the higher the cap rate the higher the perceived risk. This means that a buyer should also be considering what could happen to an asset during their ownership. What are the risks today (factored into the cap rate), and what are the risks during my ownership of the asset (could not be reflected in the cap rate).

One of the primary uses of cap rates is to compare the potential returns of different real estate investments on an acquisition basis. For example, property one has a cap rate of 5.75% and property two has a cap rate of 6.25%, the latter property would likely be seen as a high return asset but should carry more risk.

Price example at the same NOI described above:

  • Property 1: $100,000 of NOI at a 5.75% cap rate has an acquisition value of $1,739,100
  • Property 2: $100,000 of NOI at a 6.25% cap rate has an acquisition value of $1,600,000

It's important to note that cap rates are just one factor to consider when evaluating a real estate investment. Other important considerations include the overall health of the market, growth of the market, location of the property, access to the property, available parking, tenant rent levels to the market, tenant turnover, future rent growth of the tenant and the market, market population growth, along with current and future market vacancy to name a couple.

Colorado market cap rate trends

Colorado Market Retail Cap Rate Trends
Source: CoStar, 2022

The impact of interest rates on cap rates

There are several factors that influence cap rates in the real estate market. An important one, and relevant in today’s market, is interest rates. When interest rates are low, it can make borrowing for real estate purchases more affordable, which can in turn drive down cap rates. On the other hand, if interest rates are high, it can make borrowing more expensive, which has the potential to put pressure on cap rates.

In recent months, high inflation has caused the federal reserve to boost the overnight borrowing rate by half a percentage point, taking their targeted range between 4.25% and 4.50%. The Fed expects to take interest rates up to 5.00%-5.25% percent through 2023, with no signs of reductions until 2024 but only time will tell. However, in our current market, the relationship between interest rates and cap rates hasn't followed a 1:1 correlation. Cap rates have remained stubborn rather than mirroring interest rates. For example, if a net lease property's cap rate is 5.50% today, it may have only risen to 5.75% (or not at all), based on local economic conditions and future upside in a given market.

If the acquisition market thinks we will continue to see inflation, driving up replacement costs and adding to future rent growth opportunities, cap rates could stay low.

“Cap rates are influenced by a variety of factors, and they are a useful tool when looking at the initial investment decision. However, cap rates are just a quick picture of the current NOI and the current risk profile of the asset. Real estate investment decisions are more like a movie since the typical hold period for an investor is 5-10 years. A low cap rate asset could be a great investment when considering potential rent growth, future capital needs, and minimal vacancy. The opposite could be said for a high cap rate deal that contains long term rental rate risk, future capital needs, and prolonged vacancy,” stated Tom Ethington.

How other macroeconomic factors affect cap rates

Interest rates aren't the only economic factor influencing cap rates. Other macroeconomic and local market factors affecting cap rates include:

Rent growth and rent replacement

Rent growth and rent replacement should have a big impact on acquisition cap rates as this is how each asset is really valued. Rent growth can accelerate during periods of higher inflation, especially in a growth market. Properties with short-term leases could suddenly come in demand to capture this upside in the near term. If potential rent growth is strong, it can offset higher interest rates and lead to lower cap rates. During the second quarter of 2022, the rental growth of retail and industrial properties has been robust, which has helped keep cap rates relatively stable despite rising interest rates.

Gross Domestic Product (GDP) and unemployment

The overall health of the economy, as reflected in measures like gross domestic product (GDP) and unemployment, can also affect cap rates. When the economy is strong, commercial real estate investments tend to have lower cap rates. Real estate remains local. Understanding the city or town's GDP potential and employment growth is even more important than the national figures or averages.

BBB spreads

Investment bonds are often used as a gauge for the market's perception of credit risk. If the market believes that there is excess supply or an upcoming recession, the spread between BBB credit bonds and the 10-year Treasury rate may increase, leading to a potential shift in cap rate spreads. However, bonds don’t offer depreciation, possible 1031 exchange tax deferral options, and asset appreciation through rent growth like real estate so correlations to BBB rates and 10-year treasury spreads will vary.

Location

Properties in prime locations with strong demand tend to have lower cap rates (lower risk) due to strong fundamentals that drive a property's value. Great locations will lead to rent growth, and investors should target properties located in cities with population growth, employment growth, and access to housing. Properties in outlying neighborhoods tend to have higher cap rates due to unknown economic risks and varying demand by tenants causing potentially higher or longer vacancies.

Condition and age

The condition and age of the property can also impact the cap rate, as properties that are well-maintained and newer may have lower cap rates due to better credit tenants, better construction practices, and lower potential capital needs.

Tenant's credit and longevity

Tenants are the source of all cash flow in a building and high credit tenants are a more reliable and predictable source of income than low credit tenants. The better the credit the lower the cap rate as they are more stable and have a lower risk of going out of business.

Asset class

The specific asset class of the property is also important. Different asset classes will have different average cap rates due to their risk profile. Asset classes to consider are retail, multifamily, hotels, office, and industrial. All have different cap rates and are influenced by different economic variables.

Overall, cap rates play a key role in the real estate industry by providing a way to evaluate the potential return on your investment of a property at the initial acquisition. By no means should a cap rate be the only factor considered. Real estate investors should make informed decisions about which real estate investment is right for them based on the acquisition cap rate along with what will happen over the next 5 to 10 years to the asset and to the market.

Contact us directly to discuss cap rates.

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