What is a cap rate, what does cap rate compression mean and how do both affect commercial real estate valuations?
In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula below:
Capital Cost (asset price) = Net Operating Income/ Capitalization Rate
For example, in valuing the projected sale price of an apartment building that produces a net operating income of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is $142,857 ($10,000 / .07 = $142,874).
This is often referred to as direct capitalization, and is commonly used for valuing income generating property in a real estate appraisal. Capitalization rates are often used to reflect the risk of an individual investment from a market stand point. The lower the cap rate, the lower the perceived risk of a particular investment is and thus the higher the cost of the asset.
As an example, Multi-Family investments on Capitol Hill in Seattle in 2015 are trading as low as a 4% CAP Rate, while a grocery anchored retail location might be trading at a 6% CAP Rate. If each of these two properties had a Net Operating Income of $500,000 the Multi-Family Unit would have a much higher Market Valuation:
In this case, the market consider Multi-Family on Capitol Hill to have a much lower risk factor and thus a lower cap rate and higher price.
In 2010, the average cap rate across all single and multi-tenant retail investment sales in Washington was 7.5%.
In the first quarter of 2015, the average cap rate for retail investment properties in Washington is over 120 basis points lower than in 2010. The average cap rate for the 32 retail investment sales in the first quarter of this year was 6.29%.
A $5,000,000 asset that was valued at a 7.5% cap in 2010 would now be valued at $5,961,844 using today’s average cap rate. Of course, there are many other factors that play into cap rate, but that is a 19.23% increase over the last five years. In this scenario, we are not including any rent growth or debt service pay down that may have occurred which would also increase the return on equity. This is simply showing that as a market gets stronger and the perceived risk of an investment goes down, the market cap rates will compress and thus increase the value of a property.