What are Cap Rates and How to Understand Them?
What is the Capitalization Rate in Real Estate?
Capitalization rates, commonly referred to as Cap Rates, are measures used to estimate and compare the rates of return on multiple commercial or residential real estate properties. In this post we focus on multifamily rental properties or homes with five or more units held for investment, or commercial purposes. Cap rates can provide valuable insight into a property. But the cap rate is not the only metric used to evaluate a real estate investment. Investors will also want to consider the return on investment (ROI), internal rate of return (IRR) and gross rent multiplier (GRM), as well as a variety of other metrics, including the property’s individual characteristics and location. For example, a property worth $14 million and generating $600,000 of NOI would have a cap rate of 4.3% (600,000/14,000,000). That means that you can expect a roughly 4.3% annual operating cash flow given the price paid for the property.
What’s a good cap rate? It varies from investor to investor, property to property, and/or market to market. In general, the higher the cap rate, the greater the risk and return. Caps rates can be affected by various macro and microeconomic factors. “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.
Micro and Macro-economic Effects on Cap Rates
Here are a few of the factors that can have a noticeable impact on cap rates:
Rent growth: Rent growth can accelerate during periods of higher inflation, particularly in apartments with short-term leases. The anticipation of higher rents and greater NOI can offset higher interest rates. Likewise, deteriorating economic conditions can add upward pressure on cap rates and slow rent growth.
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. When GDP is low and unemployment is high, there’s a greater risk associated with investment properties. But remember: Cap rates are typically forward-looking, and individual deals are affected by a building’s unique prospects and an investor’s viewpoint—as well as the prevailing economic conditions and outlook.
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. This can lead to higher tenant turnover, leasing costs and other factors that impact operating cash flows.
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 and retail properties, and durable and nondurable goods spending is especially important for industrial properties.
Interest Rates: High inflation and the corresponding interest rate hikes can impact commercial real estate cap rates—as interest rates rise, so do cap rates. 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. In recent months, the relationship between interest rates and cap rates hasn’t followed a 1:1 relationship. Rather than mirroring interest rates, cap rates have remained stubborn, especially for multifamily and industrial properties. But according to First American’s 2022 Q1 Potential Capitalization Rate (PCR) Model update, that is changing due to decelerating price growth and continued interest rate increases, both putting upward pressure on cap rates in the second and third quarter of 2022.
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