By James Nelson
With interest rates going up, there has been a tremendous amount of discussion on how this will impact cap rates. If you read my whitepaper last month, I have shared my thoughts on the topic, but for this month’s post, I wanted to shed some light on what goes into determining a cap rate besides the interest rate environment and alternative investment opportunities.
There are two major levers when determining value for a real estate investment: the cap rate and the net operating income. The net operating income can be projected in some cases and can no doubt impact your valuation, but the cap rate utilized can make the biggest impact for determining what you will ultimately pay. For example, an investor who will accept a 4% return on an investment as opposed to a 6% return, will pay 50% more for the property. There’s an inverse relationship between the cap rate and the value. An investor who will accept less of a return will pay more for the property.
Determining the right cap rate is as much an art as it is a science, but here are some factors to consider along the way:
1. Comparable sales. Knowing what similar properties in the area have sold for on a cap rate basis is essential to understand where you should enter an investment and exit. Know the tenancy and condition of the asset to draw comparisons.
2. Location. Cap rates in primary markets are lower than tertiary due to supply and demand. There are a lot more investors looking at New York City than Binghamton, New York. More competition and investor demand in primary markets will drive up pricing and reduce returns. Reports from Real Capital Analytics will provide ranges in various markets by asset class which should help you.
3. Asset class. Multifamily properties typically trade at the lowest (tightest) cap rate because they are less risky investments, whereas a single tenant retail property (unless it has strong credit) will command a higher return.
4. Tenancy. The stronger the credit of the tenant, the lower the cap rate. A store with a lease to Walgreens will command a lower cap than a mom-and-pop shop.
5. The term. An investor will typically look for a higher return for a lease with four years left as opposed to a brand new lease signed for 10 years for fear that the tenant might not renew.
6. Upside. Investors will accept a lower return if the rent is below market. Conversely, investors will seek a higher cap rate if the lease is over market.
In today’s environment, I would focus on the last two in particular. We are once again seeing opportunities with upside for short term leases that were signed during Covid, that could now be significantly increased. This is especially true with retail. Please make sure and read my white paper on the subject too!
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