Capitalization (cap) rates are the most commonly used metric by which real estate investments are measured. Which begs the question – what is a good cap rate for an investment property? As with any complex topic, the answer is that it depends.
It’s important to remember that a property’s cap rate is simply its annual net operating income (NOI) divided by purchase price, and represents the unleveraged annual return on the asset. Because one of the driving factors is income, often times cap rates are “projected” based on an estimate of future income.
Different cap rates between properties should in theory represent different levels of risk. A lower cap rate should correspond to a lower level of risk, while a higher cap rate should imply more risk in the deal. As an investor, the challenge is to determine the appropriate risk-adjusted return, or in other words, the right cap rate given the riskiness of the deal.
When analyzing a potential investment property to determine the right cap rate, there are several core factors one can look at, including location, asset type, and the prevailing interest rate environment. Let’s examine each to see how they affect cap rates.
You are likely familiar with the old adage “in real estate, location is everything”. This is because the value of any real estate property is driven by demand, and that demand is largely affected by the location. Location can refer to both the Metropolitan Statistical Area (MSA) a property is in (e.g. Seattle vs. New York), and where within that MSA (e.g. urban vs. suburban) it’s located.
The United States consists of a vast amount of relatively undeveloped rural land, as well as 381 Metropolitan Statistical Areas (MSAs). MSA is a formal term used by the US Office of Management and Budget (OMB) to describe a geographical region with a relatively high population density at its core and close economic ties throughout the area. It is often used by real estate investors interchangeably with terms like “metro area” or “market”. Each market has its own set of underlying economic fundamentals – to take a few examples:
- Primary industries and companies
- Employment rate
- Median household income
- Education levels
These fundamentals have a huge impact on risk and therefore cap rates.
As you can see, investors were willing to accept an average 5% lower annual return in Los Angeles vs. the same type of asset in Memphis. Why? Because they perceive Los Angeles to be a less risky market based on its fundamentals. LA has a larger, wealthier, and better-educated population, which drives a more dynamic local economy and should make demand for office space stronger over the long-term.
Within the Market
As anyone who lives in or near a major US city knows, home prices are generally higher the closer you get to downtown. The same is true of commercial real estate, where prices are higher, and cap rates therefore lower, in the central business district (CBD). Investors are willing to pay more for CBD assets because, as you might have guessed, they perceive the risk to be lower than in the suburbs.
This goes back to the fundamentals of real estate being a scarce asset with intrinsic value. There is only so much land available in the CBD, and there is a natural demand for it because it’s close to other businesses and key infrastructure like mass transit, ports, highways, etc.
Cap rates also vary significantly within a market, across different asset types.
In commercial real estate, not all asset types are created equal when it comes to perceived risk. Multifamily assets consistently have among the lowest cap rates within a market, because they are considered to provide lower risk relative to other asset types. This is true for two main reasons:
- People always need a place to live, even in an economic downturn. Compare that to a retail property housing a fashion boutique or gourmet restaurant. These types of businesses can struggle even when times are good, never mind when the economy takes a turn for the worse.
- Apartment buildings generate their income from dozens or hundreds of tenants. If a few of those tenants don’t pay it doesn’t usually spell disaster for the property’s cash flow because one individual represents a relatively small percentage of the overall income. Compare that to an office building with one large tenant. If they go out of business or relocate their offices, the property may actually lose money until a new tenant can be found – no easy task in a recession.
Interest Rate Environment
Perhaps the most complex and least intuitive part of understanding cap rates is their relationship with interest rates. Often in real estate cap rates may shift without any change to the actual property or surrounding area but only as a result of a change in interest rates. That is because investing in real estate property is largely driven by the amount of debt that can be borrowed to purchase a property and the resulting spread between the interest rate and the cap rate. The larger the spread, the better the potential return. This makes sense if you think of the interest rate as the cost of money, and the cap rate as the value of that same money when invested into the property.
It’s important to note that artificially adjusted interest rates (such as those set by the Federal Reserve) can artificially impact cap rates. In other words, with no underlying changes to the real estate asset or inherent risk to the deal, a property’s cap rate can fluctuate by 0.5% - 1.0% due to the change in interest rate. While that may not seem like a lot, it can have a heavy impact on the property’s value.
For example, imagine a stabilized apartment building which was purchased for $10 million and generates $750,000 in NOI each year (a 7.5% cap rate). The property was financed with $6 million of debt at a 5.0% interest rate, which costs roughly $386,000 per year. This would make the levered yield 9.1%.
Now, imagine that a few years have passed. Nothing has changed about the deal, but the interest rate on a new loan with the exact same terms as the original has increased from 5.0% to 6.0%. This would increase the cost of the debt service to roughly $430,000 per year. In order to achieve the same levered yield of 9.1%, a buyer would only be willing to pay $9,516,000 for same property. The property value has decreased by nearly $500,000, and the cap rate has increased from 7.50% to 7.88%, even though nothing changed about the property itself.
The implication for the cap rate increase is that the risk of the investment also increased, but in reality, this doesn’t seem like the case. After all, you’re still dealing with the same asset in the same market – all that changed was the interest rate.
However, if we go back to the fundamentals of finance, you’ll recall that the return on any investment can be broken into two parts: the risk-free rate of return, which is usually defined as the rate of return on the US Treasury note, and the risk premium, which is the extra money you’re getting paid to compensate you for the additional risk you’re taking on. When the risk-free rate of return increases (when the Fed hikes interest rates), then you’re getting a lower risk premium on the same investment. In other words, you would be overpaying if you bought that property at the same original price, so the property value drops (and cap rate increases).
This principle holds true for asset values across the economy. If the risk-free rate of return increases, then the amount of money you would be willing to pay for an asset that generates an additional risk premium would decrease accordingly.
The cap rate is a comparative metric which is most valuable when it’s used to compare against very similar subject properties – that is, properties with a similar location, of the same asset type, and which are valued at the same point in time. A “good” cap rate is completely dependent upon this context. The smartest real estate investors are the ones who are willing to ask the hard questions and ensure they’re being adequately compensated for the risk they’re taking on.
Source: Fundrise, Chris Brauckmuller on May 13, 2016