What Factors Impact Cap Rates - And Will They Rise This Year?
The capitalization rate (cap rate) is calculated by dividing the net operating income (NOI) of a property by the sales price and captures a value for a slice in time during the transaction of an investment property. Cap rates can be a confusing topic; when working with an investment buyer a high cap rate is a hallmark of success, however when cap rates rise on an investment property it means the value of the property has decreased which signals a slowdown in economic growth.
The question is: what factors impact cap rates and will the recent interest rate hikes to counter inflation implemented by the Federal Reserve have an adverse effect on cap rates?
Interest rates can have a positive or negative effect on cap rates because the value of real estate is closely tied to debt financing. However, other factors including market conditions and demographics also have an equal impact on cap rates.
Historically, the correlation between interest rates and cap rates is low; according to a Capital Markets Report from Newmark, the two moved in the same direction just 43% of the time since 2000, proving that a higher cost of debt doesn’t necessarily impact cap rates. If cap rates do rise in correlation to interest rates the reasoning is simple: returns need to rise to maintain profitability which is achieved by a lower property value.
In a hot real estate market like the one we’re currently in, there’s a lot of liquidity and investors competing for properties which can offset any impact of rising interest rates. And although rising inflation has caused economic uncertainty and a plummeting stock market, this means that commercial real estate is viewed as a safer option for many investors, which will keep cap rates low.
Cap rates and commercial real estate value have an inverse relationship; when property values rise, cap rates compress. Due to the extreme demand in our current real estate climate, prices are up across nearly every sector. As of Q1 of this year, Real Capital Analytics shows a 10% year-over-year increase in the office sector, a 16% year-over-year increase in the retail sector, 22% in the apartment sector and 30% for industrial properties.
It's possible that we’ve reached or are nearing the lowest we can expect to see cap rates, but I believe they will stabilize or only experience a modest increase in the next year despite rising interest rates, due to low vacancy and strong demand.
Justin Langlois, CCIM is a Commercial Real Estate Investment Advisor with Stirling Properties servicing Baton Rouge, Louisiana and surrounding markets. Please reach out to Justin to discuss your real estate investment strategies.