What is Cap Rate Compression?
Cap Rate Compression occurs if the cap rates of properties in a particular real estate market decline relative to historical levels.
The downward pressure placed on the cap rates of specific real estate assets causes their property values to rise, which is perceived as a positive trend to market participants, such as investors.
How Does Cap Rate Compression Work?
The capitalization rate, or cap rate, is a real estate metric that describes the relationship between a property’s net operating income (NOI) and its market value as of the current date.
The cap rate is calculated by dividing the net operating income (NOI) of a property by its current market value (or purchase price).
- Net Operating Income (NOI) → Net operating income (NOI) measures the profitability of a real estate property.
- Property Market Value → Property market value represents the appraised value of the real estate asset.
The cap rates observed in the real estate markets, such as the commercial real estate market (CRE), are not static. Rather, the cap rates of properties fluctuate based on the prevailing market conditions and external factors.
The cyclical declines in the cap rates of a particular real estate market illustrate the concept of cap rate compression.
Therefore, restate investors are incentivized to identify investment properties in markets with the highest probability of cap rate compression before the actual decline in cap rates materializes.
How Does Cap Rate Compression Impact Property Valuation?
The relationship between cap rates and the pricing of properties is inversely related.
Therefore, property prices rise from the occurrence of cap rate compression, all else being equal.
- Cap Rate Compression → Price Appreciation in Property Valuation
- Cap Rate Expansion → Price Depreciation in Property Valuation
Contrary to a common misconception, however, the statement that a lower cap rate implies less risk in a potential real estate investment is not an absolute rule.
In fact, the opposite can be true at times, as the cap rates could decline after a widespread, irrational rise in property values, which coincides with factors that contribute to lower yields.
- Higher Purchase Price → Greater Risk of Overpaying
- Competitive Markets → Increased Chance of Inflated Valuations
- Cyclicality Risk → Short-Term Temporary Trends, i.e. “Herd-Like Behavior”
The most preferable scenario for real estate investors – viewed from the perspective of potentially earning outsized returns – would be if the decline in cap rates would occur simultaneously with a rise in net operating income (NOI).
The rise in property valuations benefits the returns earned on real estate investments, assuming the investor acquired or developed the property prior to the occurrence of the cap rate compression.
As with other sectors, the investors who placed their bets earlier tend to reap the most profits from being correct in their market predictions.
That said, cap rate compression can stem from an increase in property values in the absence of a proportionate rise in net operating income (NOI) – or under more favorable circumstances – the NOI of properties either increase at a comparable pace or outpace the rise in property values.
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Enroll TodayWhat Causes Cap Rate Compression to Occur?
Cap rate compression can result from a multitude of factors or a combination of them, such as the following:
- Market Supply and Demand → If the demand from buyers in a specific real estate market is strong (e.g. property location and type), competition can directly cause property prices to rise. Given higher market demand and a constant net operating income (NOI) of the properties in question, the result is a lower cap rate. In such scenarios, tenants are more receptive to paying higher rental pricing in pursuit of positively trending locations. The potential for rising rental income often causes cap rate compression over the long term, due to real estate investors becoming more willing to invest in a particular market.
- Location Trends → Cap rate compression is frequently attributable to rising competition around a specific location. Capital follows demand in the market, so more investors flock to profit from opportunities based on trends. As a recent real-life example, there was substantial cap rate compression in the Southern states, especially Florida and Texas, because of the influx in market demand stemming in part from corporate-friendly tax structures.
- Low-Interest Rate Environment → If the interest rates in the economy drop and the credit markets are favorable to borrowers – i.e. there is “cheap” capital to fund real estate projects – asset classes like real estate see a capital inflow and more activity around projects with the potential to generate higher yields. The higher demand for properties (or land) leads to an increase in property prices and cap rate compression. If interest rates decline, the average cap rates of most real estate markets compress since the cost of borrowing has come down, i.e. investors have more access to capital, enabling them to offer to pay a higher premium for investment properties.
- Positive Economic Growth Trajectory → If a particular real estate market, like a specific location, is expected to exhibit positive growth in the near term, the demand from investors for real estate assets located in that particular area rises, which effectively causes the property prices there to rise (and can compress cap rates).
What are the Implications of Cap Rate Compression?
So, what are the long-term impacts of cap rate compression?
From a high level, cap rate compression can bring the following implications:
- Lower Yields Earned by New Investors → The most straightforward impact of cap rate compression is that new investors – the buyers late to enter the market and capitalize on the trends – are likely to earn lower yields on their real estate investments. The reason is that the new buyers, contrary to pre-existing investors, are paying a greater premium for the same amount of profits.
- Higher Yields Earned by Existing Investors → In contrast, the real estate investors that were ahead of the curve with regard to entering the market undergoing cap rate compression have the opportunity to exit their investments at higher property valuations and achieve greater profits. Selling a property at a higher valuation, at the risk of stating the obvious, coincides with a higher yield generated on a given property investment.
- Increase in Property Values → To reiterate, cap rate compression causes the value of properties to increase (and vice versa). For existing property owners, the fair value of the real estate assets that belong to them appreciates in value.
- Risk of Overpaying → One of the primary sources of lower yields is overpaying for an asset. To secure properties in the target market, new investors often pay a greater premium, which corresponds with undertaking more risk related to overpaying. If cap rates were to expand, the new investors could incur losses as their investment properties are worth less than the original amount paid.
- Rising Financing Costs → While less of a monetary loss compared to the prior risks, the financing costs related to securing financing from lenders or institutional investors to fund their purchase or acquisition of properties increase if property values rise.
- Potential Pay-Off → If an investor understands the risks involved, but still anticipates cap rates to continue to compress, the investor is more likely to accept lower yields now. Why? The investor is betting on the fact that the property investment can be sold at a higher price on a future date, even if their entry is behind that of certain investors.
Cap Rate Compression Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Cap Rate Compression Example
Suppose a commercial real estate (CRE) investor acquired an office building property in Texas at a purchase price of $4 million, which generates $400k in net operating income (NOI).
- Net Operating Income (NOI) = $400k
- Purchase Price (Market Value of Property) = $4 million
Since the real estate project is an acquisition rather than a development project, the going-in cap rate (or entry cap rate) on the date of the original purchase is approximately 10.0%.
- Going-In Cap Rate (%) = $400k ÷ $4 million = 10.0%
Over the next five years, the CRE investment firm undertook long-term initiatives to improve the office building property.
For instance, long-term leases were secured with corporate tenants with strong credit ratings (i.e. low default risk) and renovations were implemented to modernize the office building.
The rationale for the firm’s property improvements was to raise the standards of the property above the bar set by comparable properties located in the same area or nearby locations.
If the market cap rate declined to 8.0% at the end of Year 5, what is the estimated property value of the office building?
The estimated property value can be determined using the following formula.
Given those assumptions, the estimated property value of the office building now stands at $5 million.
- Estimated Property Value = $400k ÷ 8.0% = $5 million
The estimated property value of the office building – even under our implicit assumption that net operating income (NOI) remained constant at $400k, which is seldom the case – rose 25% from the initial $4 million property valuation at entry to $5 million at exit.
- Cap Rate Compression (%) = 10.0% → 8.0%
- Estimated Property Value = $4 million → $5 million
- % Price Appreciation / (Depreciation) = 25%
