Cap rates in real estate can be calculated as the ratio of the property net operating income (NOI) over its market value or price:
cap rate = NOI/Market Value
Understanding the major forces that influence capitalization rates can help evaluate developments in the capital and property market and assess their potential effect on market cap rates and their subsequent impact on apartment property values and apartment prices.
According to the latest NCREIF report regarding the performance of US institutional property investments, the total annualized return in the 1st quarter of 2009 was -16.4%. This was the result of an income return of 4.6% and a negative appreciation return (decline in average apartment prices) of -20%. The quarterly decline in investment-grade apartment values was -9.9%.
The capitalization rate represents a required or acceptable income return by investors looking for properties in the local housing market. Within this framework, three major apartment cap rate influences can be identified:
a) Perceived risk associated with the property under consideration,
b) Appreciation expectations, or investor expectations for future property value increases
c) Required returns in alternative investment vehicles, such as stocks and bonds
In the real estate market, risk can be defined as the uncertainty with respect to an apartment building’s income-earning capacity and value. Investor risk perceptions regarding the prospects of an property are influenced by the economic and market conditions prevailing at the time of the purchase, especially with respect to household income and population growth, as well as real estate supply growth. All else being equal, one would expect that when the apartment market is strong, with climbing rents, high levels of absorption, and decreasing vacancies, investors will feel less uncertainty about property future cash flows and appreciation prospects. This lower uncertainty will translate to lower risk perceptions, allowing investors to accept lower returns and, therefore lower real estate cap rates.
Besides the effect of broader property market conditions the investment performance of a property is also affected by property-specific and location factors. Hence, these location and property-specific factors shape also risk perceptions and the cap rate that may be used by an investor in determining the price he/she is willing to pay for a property. For example, an investor may consider a 30-year-old building as more risky than a new one because of greater risk of functional obsolescence and greater uncertainty regarding the building’s required maintenance expenses.
Other location-specific factors that may influence investor risk perceptions have to do with the stage of development of the property’s neighbourhood. An investor may view a property located in an area with little development, infrastructure, and supporting services as more risky, compared to an apartment building located in a fully developed neighborhood.
A property in a neighbourhood that is at the early stage of its development may have greater value appreciation potential, but there is also greater uncertainty as to whether further development will eventually take place and when. That is why new massive apartment/housing development in a mostly undeveloped area will decrease the risk of existing properties and contribute to decreases in the cap rate investors are willing to accept for and increases in the value of such real estate.
Another factor that may affect an apartment investor’s required rate of return, and therefore, the capitalization rate, is expected appreciation. Investors make their decisions based on the total expected return, which is the sum of income return and appreciation return. To understand how expected appreciation may affect cap rates, consider an apartment investor who requires a total return of 10% on his/her investment. In evaluating a property for acquisition, the investor is told by a property advisor that the expected appreciation rate for the property is estimated at about 4%. Given the total return requirement of 10%, the investor will buy the property only if it is priced so that it offers a 6% (ten percent minus four percent) income return, at least.
The bottom line is that when market-wide expectations of value increases are high, capitalization rates are low; when the expectations for value appreciation are low, capitalization rates should be high. Notice that investor expectations regarding the future appreciation of a property are influenced by the same factors that influence risk perceptions, that is, indicators of market strength.
Returns in Alternative Investment Vehicles
Finally, when stocks and bonds are doing better relative to property in general and property investments in particular, there will be fewer investors and less capital chasing properties. Keeping the supply of investments constant there will be less investors competing for the same number of investments thereby allowing acquisition of such properties at lower prices, and, hence, higher cap rates. Therefore, when alternative investment vehicles are doing better than investments cap rates should be rising.