Cap Rates on the Rise
For all of my fellow real estate investors out there, you have probably noticed the same frustrating trend that I have with properties being marketed over the last few years. Every day, properties have been offered to the market with incredibly low cap rates and no potential for upside except unpredictable, hypothetical appreciation. For the majority of these properties it is impossible to make the numbers work for anyone other than large institutional investors or UHNWI looking to park money. In March of this year, CBRE and other real estate advisory firms were predicting that in 2018 we would begin to see a rise in Cap Rates. This is primarily driven by investors becoming more cautious at this stage in the cycle. Now, we’re seeing that prediction realized in New York City, the most expensive market in the country. Why is this important, and what does it mean for investors across the country?
First, for those unfamiliar, a ‘Cap Rate’ or Capitalization Rate is a fundamental concept used in commercial real estate that is defined by Investopedia as “the rate of return on a real estate investment property based on the income that the property is expected to generate. This metric is used to estimate the investor's potential return on his or her investment.” A cap rate assumes that the property is owned free and clear and does not have any debt service (mortgage payment). To calculate a cap rate you take the “net operating income,” or income after you have deducted for operating expenses, (but not debt service) and divide by the sale price of the property:
Let’s say your investment property produces $100,000 per year of net operating income and you want to sell for $1,250,000. If sold at that price, your property would have a cap rate of 8%
$100,000 / $1,250,000 = .08 or 8%
(NOI) / (Value) = (Cap Rate)
What is the purpose of cap rates? While not a perfect valuation tool, cap rates are helpful in comparing different properties in different markets and providing a high-level sense for what type of return the investment property should produce. In simplified terms, the cap rate is how much income a property produces relative to its value or cost to purchase. As a result, cap rates have an inverse relationship with value of an income generating property. When cap rates go down, value goes up, and vice versa. In the example above if the prevailing cap rate dropped to 7% and the Net Operating Income remained constant, the value of the property would be $1,428,571.43.
$100,000 / .07 = $1,428,571.43
(NOI) / (Cap Rate) = (Value)
Over the past several years, cap rates have trended downwards as investment properties have increased in value in most markets across the country. The recent data out of New York City suggests that cap rates are flattening and potentially even reversing. According to Ariel Property advisors, an NYC-based real estate services firm, cap rates in NYC rose to 3.8% in the first half of 2018, up from 3.53%. Okay, a .27% increase doesn’t sound like much; however, if we continue the above example with the property producing $100,000 in income with a 7% cap rate, the .27% cap rate increase equates to a loss of $53,055 in value since this time last year.
$100,000 / .0727 = $1,375,515.82
$1,375,515.82 (7.27%) - $1,428,571.43 (7%) - = -$53,055 reduction in value
New York City is one of the most expensive cities to live in the country. It also has some of the lowest cap rates and highest valued income generating properties in the country. Cap rates rising are the result of investors paying less for income producing properties across the board. There can be a number of reasons for the shift:
1) Growth expectations: Investors are projecting that the cash flow of the property doesn’t have as much room to grow, thus they can’t justify paying as much for the asset.
2) Opportunity Cost: Once the return on a property gets low enough, it stops making sense to allocate capital. Investors would be better off placing their capital in other assets that will generate a higher return such as, stocks, bonds, etc.
3) Interest rates increasing: With rising interest rates, investors have a harder time generating enough income to offset the cost of the higher interest on the loan.
What do rising cap rates in NYC mean for investors across the country? While again cap rates are not necessarily the best or only indicator, but the rise of cap rates in NYC could paint a picture of what is to come for other markets. Since cap rates are simply an expression of the value of an asset, it’s clear that properties decreasing in value could spell trouble for investors that haven’t protected their downside risk. When evaluating whether or not to purchase an income producing property, investors need to think critically about their business plan for the property and what happens to their investments when the value of their property drops.
The strong real estate market over the last few years has begun to shrink investor’s margins and reduce the returns on properties. Investors need to insure they have enough liquid capital, long enough term debt, and a good management plan to potentially hold an asset for a longer term than originally intended The days of buying an asset and waiting 5 years for it to appreciate naturally could in fact be coming to an end. Always remember the cardinal rule which, is to buy for cash flow and not for appreciation.
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