Hi, I’m Stewart Heath, CEO of Harvard Grace. Today, I want to talk about what’s down with cap rates. Why are the cap rates going down?
If you’re an avid real estate investor, as I am, and following the market, you’ve noticed, as I have over the last 12 months, the compression of cap rates, meaning that the cap rates are lower. How low do we think we’re going to go? I’ve attached some great articles from Cash Flow Connections and PBMares that you can read as well as listen to my post.
But first, what is a cap rate? A cap rate is short for capitalization rate and you calculate it by dividing the net operating income by the price of the property you’re looking at. That will yield you a decimal or a percentage, which is essentially the rate of investment you expect to achieve based on that price with the current net operating income. It’s similar to interest rate, that’s the investment income amount that you expect to achieve over time. Of course there are a lot of different ways to influence that. What we’ve seen is cap rates, since 2010, came down from 8, 9, 10 into 6 and 7 beginning about five years ago.
Over the last 12 months, there are some really high end multifamily properties with really strong income that are trading at cap rates in the three’s. What’s driving this? What does that mean? Well, a lower cap rate generally is interpreted as lower risk, it’s much more like an investment quality type bond, if you would. If you’re down in the three’s and you only expect that investment to perform without any hiccups the risk is low. Alternatively, a higher cap rate is something that’s perceived to have higher risk. The price will be lower in commensurate with the enhanced risk, you expect to make more off of that investment. So that’s what cap rates mean, but the other factor that’s impacting this is the financing cost.
E cap rates are inextricably tied to interest rates and as interest rates continue to live at a low, the calculation interest rates are absolutely a factor influencing the cap rate. I would expect that as long as interest rates are low, like they are now, you should expect cap rates to stay low and even perhaps get lower. Cap rates also reflect the credit quality of the tenant. You will see in various office buildings like suburban offices always have a slightly higher cap rate than a central business district office building in the same market.
There are all kinds of other factors. If we can discuss this with you, we would love to talk with you anytime you can reach out and grab my link and schedule time with me on Calendly. Otherwise, I’ll look for you online. Thanks for reading Harvard Grace Capital updates and until next time.