When analysing commercial REPE property acquisitions, investors will primarily look at the expected returns from the investment and any potential changes in value due to cap rate compression.
One of the important metric for the assessment of investment opportunities is the capitalisation rate (“cap rate(s)”) which have been discussed previously, although here is a brief recap:
What is a Capitalisation Rate?
When investing money into commercial real estate, the return on investment (“RoI”) generated is called the “capitalisation rate” or “cap rate” and is expressed as a percentage of the acquisition price.
A higher cap rate indicates that the expected returns from a property are riskier and investors will pay less for such property; a lower cap rate represents a less risky property and, hence, an investor will pay a higher price and receive a lower yield.
An alternative way to think about cap rates is that they reflect the price a REPE investor is willing to pay to purchase an income stream.
The cap rate is calculated by dividing Net Operating Income (“NOI”) by the current value of the property.
What is Cap Rate Compression?
Cap rates are not fixed either by market or by property sector. They increase and fall in response to changing market conditions.
Cap rate compression occurs when cap rates decline which, as valuations rise, which is a positive for REPE investors. In short, falling cap rates imply rising prices for a stream of income, an ideal scenario for commercial real estate investors, because it results in price appreciation and higher total returns.
Investment returns are derived from two sources, the income stream or cashflow and price appreciation. Income is derived from tenant rental payments which may increase when market factors increase demand for a property; in turn this makes investors more willing to pay a higher price for such a stream of income.
Should property cap rates compress at the same time a net operating income rises, this is an ideal situation for investors as the appreciation of rental property can be dramatic—one reason that REPE investors or syndications are highly incentivised to find properties in markets the chance for cap rate compression is the highest.
However, there are times when property values in the market will increase even though there has been no change to a property’s NOI.
It’s sometimes assumed that lower cap rates lower risk result in lower risk but this is not always the case.
In fact, the opposite may be true if the cap rate is lower because of increased property values as risks may increase as values climb.
Why does Cap Rate compression occur?
Cap rates can change for a variety of reasons and these include:
- market conditions: if overall economic conditions are healthy and population and salaries are rising and employment is high, demand for most properties will rise with the resulting reduction in the percentage of investment returns;
- changes in the supply of and demand for property: this may be due to increased supply as developers become more confident about the market and start to build more units or there is an uplift in demand from tenants for space, meaning they are willing to pay higher rental rates;
- low or falling interest rates: when interest rates are low or falling, cap rates will compress because the cost of borrowing becomes relatively cheap and investors can borrow more to acquire a property.
More investors, whether they be REPE investors, REITs, life insurance companies or hedge funds, will increase their demand for properties, producing a highly competitive market where prices rise in view of the new demand and investment yields fall;
- external factors: usually involves changes to the macro environment where there are improvements to the transport system or local authorities have places to regenerate an area or there are material changes in stock prices and more investors move into property assets. Most such events are not within the investors direct control but can have a positive impact on cap rates, causing prices to rise and cap rates compress.
CPI Capital continually monitors cap rates across the various markets across the US. In today’s low-interest-rate environment (albeit that the Fed have recently announced an interest rate increase and more hikes to come), cap rates for commercial real estate properties are at all-time lows for just about every property asset class.
Over the last 14-15 years or so, or at least since the financial crash of 2008, there has been an unprecedented increase in real estate values across the country with cap rates in some major markets now in the low single digits.
As property values are at an all-time high, this can make it challenging for new investors to enter the market and the knowledge and experience which seasoned investors such as CPI Capital can bring to REPE transactions becomes even more valuable.
It’s also more important than ever for investors to appreciate both the benefits and shortcomings of using cap rates and the possible effects of cap rate compression to evaluate investment opportunities, and to truly understand what metrics need to be analysed to make a “good” investment deal become a “great one”!
CSO, COO, Co-Founder CPI Capital