The metric can help multifamily investors assess the potential value of a property.
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What to know about cap rates
Capitalization rates—commonly called cap rates—are useful risk measurements for commercial properties.
The cap rate formula
Annual net operating income (NOI)/the property’s market value
Calculated by dividing a property’s net operating income by its asset value, the cap rate is an assessment of the yield of a property over one year.
What’s a good cap rate? It varies from investor to investor and property to property. In general, the higher the cap rate, the greater the risk and return.
“Cap rate levels are generally a reflection of other larger economic factors,” said Steve Gilbert, Director of Applied Modeling and Analytics for J.P. Morgan Investment Banking.
The impact of interest rates on cap rates
High inflation and the corresponding interest rate hikes can impact commercial real estate cap rates—as interest rates rise, so do cap rates. Cap rates tend to have a narrower range than interest rates, particularly over the short term, Gilbert said. For example, if a building’s cap rate is 4.3%, it may only rise to 4.6%, depending on economic conditions and the property supply and demand balance in a given market.
How other macroeconomic factors affect cap rates
Rent growth:Rent growth can accelerate during periods of higher inflation. The anticipation of higher rents and greater NOI can offset higher interest rates. “Recently, rent growth has slowed,” Gilbert said. “It remains to be seen if the pause is temporary or the start of a reactionary trend to a slowing economy engineered by Fed interest rate hikes.”
Gross Domestic Product (GDP) and unemployment: Both GDP and unemployment reflect the health of the economy. When GDP is high and unemployment is low, commercial real estate investments tend to have lower cap rates. But remember: Cap rates are typically forward-looking, and individual deals are affected by a building’s unique prospects and an investor’s viewpoint.
BBB spreads: “These investment bonds really measure the percepxion of credit risk of the market,” Gilbert said. “If we think things are overbuilt or there’s going to be a recession in the near future, BBB credit spreads tend to widen, which would drive cap rate spreads higher above the 10-year Treasury rate.”
Location: Proximity to the city’s employment center, highways and public transit also influences cap rates. Higher demand and stable locations generally have lower cap rates, while transitional or outlying neighborhoods usually have higher cap rates due to higher employment volatility and fluctuating demand.
Asset class: Cap rates vary across asset classes. Multifamily and industrial buildings usually have the lowest cap rates. The weight of several economic measurements may also vary based on asset class. For example, personal income is a major factor for multifamily properties.
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