What Does Cap Rate Mean in Commercial Real Estate?

The Impact of Interest Rates on Cap Rates

High inflation and the corresponding hikes in interest rates can have a significant impact on cap rates in commercial real estate. As interest rates rise, cap rates also tend to increase. However, cap rates typically have a narrower range compared to interest rates, especially in the short term. For instance, if a building’s cap rate is 4.3%, it may only rise to 4.6% depending on economic conditions, property supply and demand, and market dynamics.

In recent months, the relationship between interest rates and cap rates has not followed a straightforward 1:1 correlation. Cap rates, especially for multifamily and industrial properties, have remained stubborn despite interest rate movements. However, First American’s 2022 Q1 Potential Capitalization Rate (PCR) Model update suggests that this is changing due to decelerating price growth and continued interest rate increases. These factors are exerting upward pressure on cap rates in the second and third quarter of 2022.

“While cap rates and interest rates are loosely correlated, rapidly rising interest rates would generally imply upward pressure on cap rates. However, the change in cap rates would typically be influenced by rent growth prospects, local economic outlook, neighborhood demand/supply balance, and other unique factors specific to a property or investor,” explains Gilbert.

How Other Macroeconomic Factors Affect Cap Rates

Interest rates are not the sole economic element that influences cap rates. Several other factors come into play, including:

  • Rent growth: During periods of higher inflation, rent growth can accelerate, particularly for apartments with short-term leases. The anticipation of higher rents and increased Net Operating Income (NOI) can offset the impact of higher interest rates. Conversely, deteriorating economic conditions can put upward pressure on cap rates and hinder rent growth. Gilbert states, “Through the second quarter of 2022, apartment and industrial rent growth has been strong, allowing cap rates to remain relatively stable despite rising interest rates. However, more recently, rent growth has slowed, and it remains to be seen if this pause is temporary or the start of a reactionary trend to a slowing economy engineered by Fed interest rates.”

  • Gross Domestic Product (GDP) and unemployment: Both GDP and unemployment levels reflect the overall health of the economy. When GDP is high and unemployment is low, commercial real estate investments tend to have lower cap rates. Conversely, when GDP is low and unemployment is high, there is a greater risk associated with investment properties. However, it’s crucial to remember that cap rates are forward-looking and that individual deals are influenced by a building’s unique prospects, an investor’s perspective, and prevailing economic conditions and outlook.

  • BBB spreads: “These investment bonds truly measure the market’s perception of credit risk,” notes Gilbert. “If there is an expectation of overbuilding or an imminent recession, BBB credit spreads tend to widen. This would drive cap rate spreads higher above the 10-year Treasury rate.”

  • Location: Proximity to the city’s employment center, highways, and public transit also plays a role in determining cap rates. Higher demand and stable locations generally result in lower cap rates. Conversely, transitional or outlying neighborhoods usually have higher cap rates due to higher employment volatility and fluctuating demand. This can lead to increased tenant turnover, leasing costs, and other factors that impact operating cash flows.

  • Asset class: Cap rates vary across different asset classes. Multifamily and industrial buildings typically have the lowest cap rates. The significance of several economic measurements may also vary based on the asset class. For example, personal income plays a major role in multifamily and retail properties, while durable and nondurable goods spending is especially important for industrial properties.

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By understanding these factors and their impact on cap rates, investors can make more informed decisions in the commercial real estate market. To learn more about investing in commercial real estate, visit Garrity Traina.