In real estate investing, capitalization rate, or “cap rate”, is a textbook concept.
Simply put, the cap rate calculates a property’s natural rate of return in a single year by dividing its annual net operating income by its purchase price. And once calculated, it can be used to compare one real estate investment to another. As an investor, you’ll have the ability to evaluate one property’s cash flow against another, as well as measure the potential risk. For example, properties that are older and have fewer credit-worthy tenants may carry more risk, and as a result have a lower price, resulting in a higher cap rate. Diversity of renters, length of leases in place, property condition, and location can also affect risk and value, ultimately impacting the cap rate.1
And since valuations can be difficult to calculate, cap rates have become a valuable tool for investors looking for an apples-to-apples property comparison. Cap rates also have the ability to help asses if a market is over-valued or being sold at a discount relative to long-term market trends. Additionally, it allows buyers and sellers to pinpoint property mismanagement. For example, if a property is in an ideal location with a high cap rate, it may suggest that management has deferred maintenance or there’s a low criteria for tenants. All of this information, when coupled together, may present opportunities for value-add strategies. However, it’s important to remember that while cap rates are a good starting point in evaluating commercial real estate, they are just one of many factors to consider.
Where cap rates currently stand
While corporate bond yields have risen to 2.91 percent on average – their highest level since mid-2011 – cap rates, on the other hand, have remained steady.2 As a result, there has been a noticeable compression in spreads across all sectors in the commercial real estate market. And even though the Federal Reserve has raised its benchmark eight times in the past three years, interest rates are still historically low and have yet to materially impact cap rates.2
Tighter cap rate spreads may suggest that investors have more confidence in the commercial real estate market, meaning that there’s greater demand for real estate relative to corporate bonds, and that real estate asset values are increasing.2
Overall, 2018 cap rates have remained relatively stable across most sectors, other than higher movement in certain retail segments, thanks to global capital flooding into the market, above-trend economic growth, and continued low interest rates.2
Cap rates effect on the multifamily market
Cap rates on apartment real estate acquisitions remain at historic lows, averaging well under six percent, and strengthening the argument for high demand and increased confidence in the multifamily sector.3
Consider this: people need a place to live, no matter what the economic conditions. Compare that to a retail property providing space to a fashion boutique or a gourmet restaurant. These businesses struggle when the economy takes a turn for the worse and money becomes tight. Additionally, apartments generate income from hundreds of tenants. If several tenants don’t pay their rent, it typically doesn’t result in a disaster for the property’s cash flow. But if an office building’s largest tenant goes out of business or relocates to a new office, the property is much more vulnerable – especially during a recession.4
Utilizing cap rates in today’s investment environment
Considering today’s economy and evolving investment environment, it’s more important than ever to understand the importance of cap rates and how you can use them when comparing properties.