When do cap rates change?

5 Replies

Hey guys, I wanted to ask the experienced MF investors the following (from an economic cycle standpoint)-

  1. When does the cap rate of a local neighborhood/market change? What are the economic factors which affects the cap rates?
  2. How fast/slowly does it change?
  3. How do you factor that into your investment strategy (2-5 year strategy)? E.g. If you are buying in low cap rate markets and foresee that they can increase (thus bringing down the value of your asset)...what do you do?

@Jay Pillalamarri there is only one factor that influences market cap rate:  supply and demand.

When demand is high, investors are forced to bid against one another, driving prices up and cap rates down.  

When demand is low, prices fall which means that cap rates rise.

So the real question is what influences demand?  There are many factors.  Interest rates.  Return on investment thrown off from other investments carrying similar risk.  Fear.  Greed.  Rumored or known neighborhood revitalization or economic development. Overall economic strength or weakness.  Heck this list could go on and on and on.

How fast or slow does it change?  Values could rise or fall tremendously in an instant  so there is no standard here.  Imagine if you were in a sleepy 10 cap market that’s been dead for decades and Amazon suddenly announced they were moving their headquarters there. Cap rates would move quickly and by a lot. Or if you were in a great market that was humming along with low cap rates and then there was an accident at the nuclear power plant and the population started moving as far out of town as they could. But generally the good news is that real estate isn’t like stocks and commodities, you don’t have to turn on the TV every morning to find out if you are rich or poor.  It tends to move somewhat slowly most of the time.

How do I factor cap rate into my investment plan?  I expect that caps will rise, and I underwrite to a higher exit cap than is market today. There is a huge demand for real estate now so to assume that there will be just as much, or even more, in the future strikes me as overly optimistic.

@Brian Burke -

Thanks Brian! Great explanation. Could you please elaborate on that last point. "I expect that caps will rise, and I underwrite to a higher exit cap than is market today."

  • How much "higher?" E.g. Let's say that you are buying in downtown Seattle and the rates are in the 3-4% range. So how much higher are you saying? Does it depend on the market (e.g. Seattle vs Cleveland). Or is it a constant - like "for every 5 years of holding, you add 1%." Could you please share your thought process?
  • What do you mean by "I underwrite at a higher rate." Are you saying, that you negotiate the purchase price of the property at a future cap rate (based on how long you intend to hold it)?

Jay,

RE investment 101 says that higher CAP rates translate in to lower sale prices.

Unless there is a value add play or anticipated strong appreciation going on, at 3 - 4% a buyer is not making much if anything unless they are all CASH. Don't forget that CAP rates are before financing, CAPEX reserves and even basic inflation.

On your second point, there is no future negotiation of a sale price. Rather I believe what Brian is referring to is the assumed exit conditions. While ultimately unknowable until sold, an estimate sale price (aggressive or conservative) is part of the overall investment analysis.

Oren

@Jay Pillalamarri first you have to find a starting cap rate. According to the CBRE cap rate study for the first half of 2017, Seattle cap rates for infill class A ranges from 4.25 to 4.75. So let’s say you decide 4.75% is the right number. I then grow the cap rate by 1/10% per year until my assumes exit year.

I don't use cap rate to determine my purchase price, only my exit. I use IRR to determine my purchase price.

Join the Largest Real Estate Investing Community

Basic membership is free, forever.