Why have cap rates declined precipitously over the last 6 years? Why do cap rates decline at
all? What factors create a declining cap rate? If you are an investor then by definition you
should be intensely interested in the future of your investments. It is therefore imperative for
any real estate investor to understand the most consistently used ratio to value commercial
real estate.
The definition of the cap rate, shown below, seems simple enough, but the complex factors
that influence this little ratio are buried beneath the surface.
Cap Rate = Net Operating Income
Property Value
Put simply there are three influencing factors of the capitalization rate which I will break
down one at a time.
1. Cash Flow
2. Risk
3. Speculation
1. Cash Flow
Property values historically increase at the same pace as rent growth. If rents and values
really do move in tandem over time then why would the cap rate change at all? Part of the
reason lays in the fact that cap rates are almost always reported using trailing twelve month
NOI but property values always reflect the expected future earnings that an investor hopes to
collect. Therefore the numerator in the equation is backwards looking while the denominator
is forwards looking creating a fundamental disconnect at the time of sale.
Cap Rate= Trailing Twelve Month NOI <-- Backwards Looking
Property Value <-- Forwards Looking
Although historical NOI is a helpful indicator in determining future NOI it is only an
indicator and is never what the investor focuses on when valuing a property. It should,
therefore not be included in an equation used to value a property. However if we can change
the equation so that it represents how an investor looks at the property by using the expected
future earnings that an investor hopes to capture, then the equation would be in alignment
and would look something like this:
Cap Rate= Expected NOI Over Life of Investment <--Forward Looking
Property Value <--Forward Looking
In a world without speculation or changing risk preferences and with reliable data for
expected NOI in the numerator, then our graph would look something like this even if
earnings growth were expected to double.
2. Risk
Why doesn’t the cap rate change? The answer lies in the risk side of the equation. In this
perfect world we have created above, the only factor that would actually change the cap rate
would be if investors were willing to change how much they are willing to pay for the
expected cash flows of commercial real estate. This is why I emphasized changing risk
preferences above. In that perfect world we assume that only one risk preference exists and
that preference is set at a 9% cap rate.
If we rearrange the cap rate formula then these risk preferences become more apparent. If a
market has an 8% cap rate then it can be said that for every $1 in earnings an investor is
willing to pay $12.50 dollars (1/0.08) for the property. This 1 to 12.5 ratio represents the
investor’s risk appetite for commercial real estate cash flows. In this way we can write out
the cap rate equation as:
Risk Appetite (8%) = Earnings ($1)
Value ($12.50)
If earnings increase exponentially, but the risk appetite remains the same then the nominal
value will increase accordingly as shown below.
Risk Appetite: 8% (No Change) = ↑ Earnings: $2 (100% increase) = $1
↑ Value: $25 (100% increase) $12.5
I include the $1/$12.5 at the end to remind you that no matter how much earnings increase
the ratio remains the same even though the nominal value of the property might have
increased dramatically. However, when investors do change their risk preferences change the
effect on property value can be dramatic.
↓ Risk Appetite: 10% (25% increase) = Earnings: $1 (No Change)
↑ Value: $10 (20% decrease)
To fully understand why investors change their risk preferences for real estate we must take a
10,000 foot perspective on the asset class of commercial real estate. In the last ten or so years
Wall Street has made great strides at making investing in commercial real estate as easy as
buying another stock on the exchange. Because real estate has become similar to stocks and
bonds then investors must look at the returns of all three asset classes before deciding where
to invest their money. If the cap rate represents the expected yield to investors in real estate
then it is comparable to yield measurements used in the other asset classes such as the
Price/Earnings ratio used for stocks and the bond coupon, which is the interest income
divided by the price paid for the bond. Each yield tells us how much an investor is willing
to pay for the expected cash flows of that asset class.
The reason why investors would change how much they are willing to pay for real estate cash
flows is because of a change in perceived risk of real estate versus the other asset classes. A
good example of this was the aftermath of the dot com crash when investors fled from stocks
and poured their money into real estate as it was perceived as a much safer and more stable
investment than the alternatives. Thus investors were willing to pay more for the cash
flows produced by commercial real estate assets thereby driving down the cap rate,
which is displayed graphically in the chart at the top.
3. Speculation
So far we have discussed how price reacts to cash flows, but what happens when price reacts
to price? The third and final factor affecting the cap rate is speculation defined as
“Engagement in risky business transactions on the chance of quick or considerable profit”
(Dictionary.com). Speculation in real estate means buying a property in the hopes of selling it
one day for a greater price than can be justified by any increase in the cash flows.
Speculation will always be prevalent in real estate and therefore must be considered as just as
major of a factor in breaking down the reasons for cap rate movements.
Speculation can significantly affect the property value portion of the equation so much so
that all other factors essentially become drowned out. Although it is difficult to determine
how much risk or speculation is contributing to a lower cap rate, it is helpful to compare the
annual cash returns investors are getting (the cap rate) versus other comparable asset classes
(such as the P/E ratio or the treasury yield) and then determine if the returns in real estate are
reasonable. If they are not reasonable then it is safe to assume that speculation has taken hold
of property values.
In a purely speculative environment the cap rate is no longer a meaningful
measurement because cash flow is not the driving factor of price determination.
