Thursday, July 7, 2011

Test Your Cap Rate Knowledge!

What is a cap rate? It is simply the net operating income (NOI) of the property (before any debt service) divided by the price and it equates to a percentage rate of return if the investor were to purchase a property with no debt (all cash).
Example: NOI = $100,000, Price $1,200,000 CAP rate = $100,000/$1,200,000. Result: Cap Rate = 8.3%.

Supply and demand and the cost of debt are two factors that affect cap rates in a market place. The cap rate is one of the primary determinates of pricing for investment property and there is a direct correlation between market cap rates and current available interest rates for debt on investment property. When interest rates are lower than cap rates, we end up in what we call a positive leverage market; the more you borrow the higher your return on investment will be.

When interest rates are greater than cap rates, we are in what we call a negative leverage market scenario; the more you borrow against a property the lower your rate of return is on the investment.

It is also important to understand that the primary advantages of real estate over other investment types are leverage and tax advantages. Most real estate investors want leverage as much as possible as most of the advantages in owning real estate come with leverage. Just like in any other investment type, real estate is driven by supply and demand. Investors in real estate normally have a certain threshold of investment return they are willing to accept depending on the asset and the current market.

As interest rates decline and the cost to borrow decreases investors are willing to accept a lower rate of return on their cash because other investment vehicles offer lower returns.
As interest rates decline, two market forces working to drive an increase in real estate prices: (1) Cap rates are decreasing with interest rates and (2) Investors are willing to accept a lower rate of return on their money.

Conversely, in a rising interest rate environment, the opposite is true. When there are more options for investors to achieve a greater rate of return and the cost of debt increases, cap rates increase and reduce the price an investor is willing to pay for an asset.
In conjunction with these effects, the market also plays an important role in CAP and interest rates. The higher market demand is in a particular market, the lower CAP rates tend to be.
Lower cap rates have a positive affect on prices. Alternatively in a weaker market with lower demand, cap rates rise and values decrease.
Portland/Vancouver Metro Area Median CAP Rates for Apartments 2001-2010
2001 8.21%
2002 8.30%
2003 7.60%
2004 7.20%
2005 6.60%
2006 6.30%
2007 6.10%
2008 6.10%
2009 6.80%
2010 6.80%

Tim O’Brien is a partner at HFO Investment Real Estate. He can be reached at 503-241-5541 or by e-mail at tim@hfore.com.

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