What Are Cap Rates?
Depending on the side of the transaction an investor finds themselves, capitalization rate compression can be favorable or costly. Although other factors must be considered when evaluating a real estate transaction, the capitalization rate, or cap rate, remains a paramount figure for most private investors as they chase higher yields on their investments. In this article, Matthews™ explores the concept of cap rate compression and what it means for commercial investors.
What is Cap Rate Compression?
Cap rate is a commonly used valuation metric that measures an investment’s income potential in relation to the asset’s purchase price. The higher the cap rate, the more income an investor can expect in relation to the asset’s purchase price. Cap rate compression refers to rising market prices of investments in relation to the income the investment will generate. In short, cap rates are inversely related to market pricing; thus, when cap rate compression occurs, prices increase without a relative increase in rental income. Following the laws of supply and demand, cap rate compression may result from high investor demand or a general lack of quality inventory, resulting in higher prices for the same assets. In addition to the market’s overall supply and demand, cap rates are also correlated with the debt market. When debt is cheap, buyers can pay relatively higher prices for the same opportunities while still yielding the same cash flow. Of course, cap rate compression is a positive for property owners. With higher market prices for assets, sellers can capitalize and make more profit on the sale, refinance, or withdraw cash for reinvestment. On the other hand, cap rate compression is generally viewed as a negative to real estate buyers. As cap rates compress, the amount of money needed to produce the desired amount of income will rise, making it less lucrative to buy commercial real estate.
The Factors Influencing Cap Rate Compression
Cap rate compression largely represents market recovery. Three factors that have historically influenced cap rate compression are location, sector shift, and economic environment.
Cap rate compression can be attributed to increased competition within a market. With the immense national investor pool seeking to move their capital into more business-friendly states, the number of investors vying for the same opportunities has increased in certain markets. Throughout 2022, cap rate compression was most notable in the Southeast and income tax-free states as these markets see an influx of competition and capital from investors located in less business-friendly environments. This migration of capital has caused the pricing for apartments and industrial properties in secondary and tertiary markets to rise dramatically over the past year, especially in the Southern region of the U.S. or in states along the Sunbelt. In 2023, cap rates have experienced a 94 basis points decline. These transactions displayed an average cap rate of 5.97% during Q4 2022, compared to 5.04% in Q1 2023.
Mainly due to the pandemic and e-commerce shifts, there has been elevated interest in industrial, corporately-backed retail, grocers, and drugstores. Where e-commerce pushed investors to favor more service-based tenancy rather than soft goods retailers, the pandemic has further restricted investors’ target tenancy to favor essential tenants. Investors are seeking security in these properties, but supply is limited. Accordingly, pricing continues to rise due to increased competition from investors eyeing changing supply metrics.
Cap rates have generally compressed since the recession in 2012 due in part to decreased treasury yields, courtesy of the Federal Reserve. A low-interest rate environment and high levels of liquidity help drive strong pricing in the coveted real estate sectors to near or above pre-pandemic levels in many locations, especially those with business-friendly policies. For example, the Southeast has experienced one of the most dramatic cap rate compressions since the Great Recession.
How Have Cap Rates Adjusted?
The dynamic debt market of today has further complicated the scope with which investors have to view each individual asset. Investors will inevitably look to maintain their spread between their cost of capital and the yield of prospective investments. As the cost of capital continues to rise with the Fed’s increasing of interest rates, market cap rates across all asset classes can be expected to rise accordingly. While market cap rates across each asset class will have to rise to accommodate the growing cost of capital, investors can expect cap rate movement to vary across property types through 2023.
For the fifth consecutive quarter, cap rates within the single-tenant net lease industry have risen. The average now stands at 6.40%, reflecting a 13 basis point surge compared to the previous quarter. The increase in interest rates, coupled with the potential returns offered by alternative fixed-income investment options, remains the key factor contributing to the upward push on capitalization rates.
Multi-tenant retail centers achieved significant milestones by Q4 2022, including 146 transactions, a sales volume totaling $1.277 billion, and the lowest annual average cap rate since 2007, at 6.46%.
Cap rate compression is especially prevalent for grocery-anchored centers, which generally fared better within the retail sector in 2022 and 2021 than in 2020. However, the cap rates paid for grocery-anchored retail centers are heavily influenced by the property’s market and the specific grocery store that anchors the center. Multi-tenant retail assets allow an owner more discretion in increasing cash flow through ownership, but this sector will also see an increase in market cap rates as investors look to maintain their spreads between available asset yields and their financing options.
As of Q3 2023, the national asking cap rate for industrial properties currently averages 5.6%, but these rates are expected to tick up modestly as the rising interest rate environment continues to affect prices investors are able to pay. Unsurprisingly, cap rate compression among industrial real estate was quite substantial throughout 2022, as it was one of the hottest asset classes pre-pandemic and since the introduction of COVID-19. The lowest cap rates for industrial properties are in the Northeast and Western regions of the United States.
The national asking cap rate for multifamily is expected to hover at or above 5.0% for the remainder of 2023. Although the multifamily sector will continue to see substantial demand due to investors’ ability to raise rents as a hedge against inflation, market cap rates are likely to rise in the coming months as the available debt for these assets grows increasingly less favorable.
As the United States emerges from the pandemic and interest rates continue to climb, cap rates will remain fluid, with the real estate market reacting accordingly. Essentially, a shrinking cap rate signifies an increase in real estate investment prices, and this is exactly what the market has seen in recent months. However, long-term interest rates will follow if inflation continues to grow as the 10-year Treasury yields rise. With a higher cost of borrowing and no increase in real income, cap rates can generally be expected to rise over the next year. In summary, cap rates may be affected by a multitude of external factors and can provide savvy investors insight into where market interest is strongest.