Capitalization rate, or cap rate, is one of the most important metrics in real estate investing to know. This is not only because cap rate can help you determine how much income a potential real estate investment could produce, but also because it can help determine the market value of commercial real estate assets.
In this article, we'll take a closer look at the concept of cap rate compression and what it might mean to you as a real estate investor or property owner.
What is cap rate?
Cap rate, or capitalization rate, is one of the most important real estate metrics for new commercial property investors to learn.
Fortunately, it's rather basic from a mathematical point of view. To calculate a property's cap rate, simply divide its annual net operating income (NOI) by its purchase price or market value. For example, a property with an annual NOI of $50,000 and a $1 million market value would have a cap rate of 5%.
Typically, cap rates are calculated initially when a property is purchased, known as the initial cap rate. Another common use is the exit cap rate, which is calculated when a property is sold. However, it's certainly possible to calculate a property's cap rate at any point of ownership, using the past 12 months' worth of NOI and the property's current value.
Cap rate can be used both as a method of evaluating income from a commercial property and as a way to value a commercial property based on the income it generates.
Cap rate compression in a nutshell
Cap rate compression refers to a phenomenon of cap rates falling because a real estate market is rising. As we saw in the last section, cap rate and property value or property price have an inverse relationship with one another, so the lower cap rates fall, the higher prices will go relative to the income a typical property will produce.
In short, cap rate compression refers to an increase in commercial real estate prices without an increase in rental income. This can be caused by a few reasons. For example, high demand or low inventory can create a "hot" market, and prices can rise in order to satisfy the demand. Falling borrowing rates also tend to lead to cap rate compression -- as it becomes cheaper to borrow money, sellers can demand higher prices from buyers.
What cap rate compression could mean to you
There are two main reasons commercial real estate prices can increase. One is because market rent is rising. For example, if the average office tenant in your local market is paying 5% more in rent than they were a year ago, it's reasonable to expect that property values have risen by a similar amount, with all other factors being equal. I'd call this the more "neutral" of the two for buyers and sellers. In other words, buyers will pay more for properties, but they can get more income for their investment dollar in return
Cap rate compression is the other reason commercial real estate prices rise. Cap rate compression can be caused by a number of reasons, as mentioned earlier, but it can have big implications for property owners and investors.
For property owners, cap rate compression is a good thing. Think of it this way. Let's say you pay $1 million for a property that generates $70,000 in annual NOI, so your initial cap rate was 7%. Now, let's say that because of strong market conditions, cap rate compression has made the going rate for properties like yours 5%. Working backwards from your property's $70,000 in NOI and dividing by your 5% cap rate gives a new market value of $1.4 million. You can now sell the property at a nice profit, or potentially refinance and take cash out to reinvest elsewhere.
On the other hand, cap rate compression isn't a very good thing if you're in the market to buy real estate. As cap rates get compressed, the amount of money you'll need to invest to produce a desired amount of income will rise, making it less lucrative to buy commercial real estate in your desired market.
The Millionacres bottom line
Cap rate compression can be your best friend if you own commercial properties in a hot real estate market, or it can be your worst enemy if you have capital to deploy. In either case, cap rate and cap rate compression are important concepts for commercial real estate investors to understand.