Capitalization Rate Cycle
What is a capitalization rate cycle and does it exist? Well, if there is a property market cycle then there is also and a cap rate cycle.
It is understood that movements in capitalization rates are influenced by both property market fundamentals and capital market fundamentals. Empirical evidence has shown also that there is a property market cycle, which is manifested in cyclical movements of rents and vacancy rates of properties from low to highs and vice versa. Wheaton (1987) has documented this cycle in the office market.
Real Estate Cycle
The property cycle is primarily due to inefficiencies in the market and the sluggish adjustments of supply and market rents to changes in demand, as well as slow adjustments of demand to changes in rents, supply and economic conditions. When a demand shock occurs, such as the significant drop in demand that occurred due to the 1991 recession, because supply is fixed in the short term, the vacancy rate increases rapidly. As a result, rents start to decline in order to bring demand and supply back into balance.
The decrease in rents, when it reaches sufficient levels, will have two effects. On one hand, it will trigger increases in demand and, on the other hand, it will discourage developers from completing and putting more space in the market. As a result of these adjustments, which do not happen instantly but through time, vacancy rates will start gradually declining. According to theory, rents will continue to decline until the vacancy rate decreases to a level referred to in the literature as structural or normal vacancy rate, which is considered as the minimum vacancy rate required in the market in order to allow normal search processes both on the part of buyers/renters looking for space and landlords/sellers looking for tenants/buyers. That is the level at which theoretically demand for space is equal to the supply of space.
Any further decrease of the vacancy rate below this level denotes that demand exceeds supply, a situation that according to conventional economic theory should trigger increases in rents. Due to sluggish adjustments of supply in responding to the higher levels of demand, rent increases continue for a while before the market comes back to balance. It should be noted though that due to the dynamic nature of the economy and the fluctuating demand growth rates, as well as the difficulty of suppliers in anticipating correctly the level of demand that will prevail when their projects will be completed, the property is rarely at equilibrium.
Cap Rate Cycle
According to empirical evidence, the cap rate cycle moves in a countercyclical way in relation to the property cycle. In particular, empirical evidence for the U.S office market (Sivitanidou and Sivitanides, 1999) shows that when rents are high and property market conditions are strong cap rates are low. Based on this relationship one can argue that cap rates reach their lowest value when rents reach their peak. Conversely, cap rates reach their peak when rents hit bottom. This relationship between rents and cap rates suggests that values take a double hit when the rent cycle reaches bottom. Since according to the direct income capitalization approach the value of income-producing property is equal to the ratio of the net operating income (NOI) (see more here) over the market capitalization rate, when the property market is at the bottom of the cycle the numerator will have its lowest value and the denominator (the cap rate)will have its highest value, thus reinforcing the negative effect of a recession on property values.
Looking at the capitalization rate cycle and the property cycle strategically, the conclusion is that property investors that buy at the bottom or near the bottom of the cycle will be able to realize significant capital gains or high appreciation returns because values will benefit both from rising rents and declining capitalization rates as the market recovers and rents move to their peak.