Cap Rate Compression- What Is It?
CAP rate vs. Pro Forma CAP rate vs. CAP rate compression
Finding an amazing investment opportunity and negotiating the financing with your lender takes a lot of patience and skill.
However, before beginning your investment property search, you must understand the difference between the CAP Rate, Pro Forma CAP Rate, and Cap Rate Compression, and how you can use each of these calculations to make better real estate investments.
The Capitalization Rate, also known as the “Cap Rate,” is arguably one of the most fundamental real estate investing concepts; however, it is frequently misinterpreted.
The Cap Rate formula analyzes a property’s annual rate of return, assuming that reliable tenants occupy the property.
Notably, the Cap Rate is calculated without including any of the property’s debt because this makes it easier to compare the value of multiple properties to one another. Overall, Cap Rates are a key performance indicator for real estate investors.
You can calculate a Cap Rate by dividing the property’s net operating income (NOI) by the property value or the sales price of the property.
To calculate the NOI, you must combine all the property’s streams of revenue like the rent collected, laundry income, parking etc. Next, subtract all non-variable expenses such as taxes, insurance, and management fees.
The final number is the Net Operating Income (NOI) for the building. Next, take the NOI number and divide it by the purchase price of the building or the building’s value to calculate the Cap Rate.
CAP Rate Formula:
The algebraic CAP rate formula is as follows: CAP rate = Net Operating Income (NOI) / Property value (or sales price).
For example, let’s hypothetically say that property has a value of $1 million. The NOI is $50,000. The property’s CAP rate therefore is 5%: $50,000/$1 million = 5%.
Now let’s hypothetically say that the building next door to the above property has the same square footage, and is almost identical, but is generating $100,000 in NOI for the same $1 million price point (Cap rate is now: $100,000/$1 million = 10%)
Which one would you want to buy? Buyers usually want higher cap rates, because that means that the price is lower compared to the NOI.
The cap rate of properties changes if either the property value changes or NOI changes. Keep in mind that property value is influenced by various market influences, such as market demand and interest rate. As such, the Cap Rate for a property can change even when there’s no change to the NOI.
Additionally, CAP rates can vary by city and neighborhood. Even certain pockets within a neighborhood can have varying Cap Rates depending on market conditions. A building in one section of a city can trade at a 5% CAP Rate, while a similar property at the other end of the city can trade at 8%.
Overall, the average CAP rate in the US can range from 5% to 9%.
As explained below, the Cap Rate, the pro forma Cap Rate, and the Cap Rate compression all involve different formulas.
Pro Forma Cap Rate Calculation
The pro forma Cap rate calculation is similar to the algebraic calculation used to determine the Cap rate, except when calculating the pro forma cap rate, you add any repair costs to the purchase price of the property.
Pro Forma Cap rate = Net Operating Income after repair costs (NOI) / Property value or Sales Price
Let’s say the building is $1 million, and the building’s profit (NOI) is $50,000. If it cost $100,000 to repair, then the pro forma Cap rate is $50,000 / $1,100,000 = 4.54%
Notice that the Cap rate is 5%, and the Pro Forma Cap rate is 4.54%.
Now let’s work to understand the term ‘cap rate compression’.
Understanding Cap Rate Compression?
Occasionally, the market will increase property values even though there has been no change to a property’s NOI.
By raising a property’s value, this effectively lowers its Cap Rates, and this is called Cap Rate compression, and Cap Rate Compression typically is indicative of rising market prices and the fact that investors perceived certain asset classes as low risk, high reward properties.
While some investors mistakenly assume that lower Cap Rates automatically means lower risk, this is not always the case.
In fact, the opposite may be true if the Cap Rate is lower because of increased property values.
Compressed Cap Rates may be great for investors looking to relinquish properties; this may not be good for new investors trying to get into the market.
Cap Rate compression may occur when there is an influx of cash in the market.
For example, REITs, hedge funds, and other institutions such as life insurance companies start paying record-high prices for properties; this produces a highly competitive market that brokers, and other sellers often take advantage of.
When interest rates begin to rise, additional pressure is placed on real estate investors who typically leverage their investments with debt.
This means that when property yields come in at or lower than market interest rates. Since the majority of real estate investors depend heavily on leverage to purchase investment properties, Cap Rate compression ends up locking many real estate investors out of the market temporarily until either Cap Rates rise or interest rates decline.
When yields are at the point that real estate investors can’t borrow to purchase real estate, the market tends to peak.
When Should You Avoid Using Cap Rates or Cap Rate Compression?
Cap rates are a critical valuation tool for real estate investors when used correctly. However, Cap Rates should not be the sole determining factor used by an investor when making investment decisions because, in some scenarios, the cap rate doesn’t accurately portray the investment opportunity.
For example, investors should not use cap rate when evaluating short-term investments like fix and flips.
Specifically, these types of short-term investments do not require general income from rent, and therefore the quality of the investment cannot be measured by using a cap rate.
Investors must also understand that the cap rate is not the same as cash-on-cash return, which is determined by the amount of cash a property generates after the mortgage and other expenses are paid divided by the total amount of cash invested.
Both calculations are useful in evaluating the potential profitability of an investment; cash-on-cash considers debt on the asset while the Cap Rate does not.
Cap Rates & Cap Rate Compression in 2020
In today’s low-interest-rate environment, Cap Rates for commercial real estate properties are at all-time lows for just about every asset class.
This low-interest-rate environment is due primarily to the Federal Reserve’s policy decisions, not necessarily market-driven forces.
Since the housing crash of 2008, we’ve seen an unprecedented run-up in real estate values across the nation; in markets like New York and California, cap rates are now in the low single digits.
Since the cap rates have been lower, property values are at an all-time high, making it challenging for new investors to break into the market.
Given the current macroeconomic environment, it’s more important than ever for investors to appreciate both the advantages and shortcomings of using cap rates to evaluate investment opportunities.