Cap rate is the ratio of net operating income over the property value.
It is not a function of the financing rate used to acquire a property.
It is a good tool to compare various commercial assets just based on the cashflows those assets produce and the asking price or market value they command.
For that reason there is no direct relationship between cap rates and interest rates.
It is more of an indirect one. In an environment of raising interest rates, you are right to question how this would affect the value of multifamily.
Will this cool down the demand for multifamily because of the tightening of the lending conditions ?
In my view, probably! If people have higher rates to pay and can afford to borrow less, there will be less demand for the same supply.
In other words, with less buyers, the cap rates should increase because of the stabilization or lesser increase of property values compared to rents.
I have been calling for the demise, or at least slow down of multifamily for some time, and I've been wrong. There are demographics in play here, along with a strong economy and local factors.
Millennials are delaying the purchase of a home and baby boomers are down sizing, creating demand. Affordable housing needs are about 150k units per year, and we are only producing 50k, which will go down due to the new tax bill.
People have a stronger appetite to rent than to buy right now. It might change. Also, people are migrating to certain ares of the country, which is creating a demand.
@Michael Evans Historically rising interest rates have caused expansion of CAP rates. A softening of the market so to speak. Since most larger -50 units and up- MF assets have leverage, when the cost of that leverage is going up... the NOI comes down.... lowering overall asset value. @Gino Barbaro is dead on when he pointed out above, this is a different era and the CAP rates have remained compressed longer than most MF investors have expected due to three factors 1)Downsizing Baby Boomers, 2) Gen X/Millennnials delaying the purchase of a house, and the rapid growth of migrant population coming from countries where home ownership is not even a possibility for most. Another factor he correctly mentioned is net domestic migration... Americans leaving high unemployment/high tax states and moving to low tax/low unemployment job creating cities and states. Its a very valid question to ask how does one protect himself in these times when considering MF investing? Cash FLOW!
You have to buy the asset right and insure cash flow. You cannot count on appreciation in a rising rate environment. Many MF investors found this out in 08 when the appreciation they were counting on disappeared. You can buffer the effects of expanding cap rates buying value add properties but right now cash flow is king.
I want to point out that the feds raising the funds rate impacts short term interest rates. Long term interest rates, such a 30-year mortgages, are more impacted by the 10-year treasury. And the 10-year treasury goes up and down based on demand of that note.
So yes, cap rate generally trends with the interest rates but long term interest rates and not necessarily the Federal Reserves overnight funds rate.
I remember seeing a graph based on historical data on Marcus Millichap's site showing that interest rates do generally trend with cap rate. As you pointed out it is the long term interest rates. I would put the link to that graph but I couldn't find it.
Rising interest rates usually lead to investors to revise UP their required rate of return on just about any type of investments. In the multifamily space this upward revision takes the form of investors not willing to pay as much for NOI compared to when interest rates were lower (i.e. NOI becomes "cheaper"). So yes this leads to downward pressure on asset valuation but it is due to NOI being cheaper not NOI being lower. I agree that when interest rates go up, the cost of leverage goes up but the increase in cost of leverage does not drive down NOI, does it? NOI does not include cost of leverage, does it?
There are investors predicting a downturn and there are investors predicting a continued strong market. There is one certainty...one group will be right.
@Michael Le you are 100% correct. I run a practice full time and was sneaking out between patients ... multi-tasking and you caught my mistake. Should have been ROE (return on equity) not NOI. You are correct that NOI is not "directly" affected by cost of leverage. The way that changes in interest rates affect commercial real estate values is more complicated than it seems on the surface. I have included one of the better articles from Investopedia that dumbs it down enough for non-economists like me to understand it:https://www.investopedia.com/articles/mortgages-real-estate/08/interest-rates-affect-property-values.asp
I would say higher interest rates will decrease property values, but it likely won't be in line. There are a lot of demand factors in place to keep multi-family strong. If interest rates jump up, however by 3% in the next few years it will put a large strain on all real estate. Buying now conservatively at low interest rates with a 10 year lock could be a great thing.
Some things to remember:
Multi-family has been ready to crash for 2-3 years according to many people and still keeps going up.
Interest rates have supposed to been going up for 5+ years and they keep hovering around the same rate.
If rates did increase by as much as 3% that would mean the Fed is trying to control run away inflation which would be a great time to own debt (and we would all be kicking ourselves for not owning debt when the getting was good). While a hike of that magnitude would put downward pressure on prices the price of almost everything would have increased astronomically to call for such a hike. Can you imagine how the President (which ever party) would be throwing a fit if the Fed raised rates enough to put the breaks on the economy, it would create political chaos. Our country and world could use some inflation and I assume governments such as ours will keep encouraging it as much as they can by being extremely cautious in raising rates. The major risk I see in harming the price of multifamily is deflation caused by an economic downturn.
For what it is worth I am still buying and leveraging (at least trying to). But as my dad likes to say free advise is worth what you pay for it.
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