The direct capitalization method is perhaps the most common metric used when discussing real estate property values. It’s a simple way to measure what investors are willing to pay for a particular asset class/property type in a particular market. Despite their usefulness and dominance in real estate conversations, cap rates have significant limitations in analyzing an investment’s true value. Here are the 4 things that cap rates are not telling you:
- Cap rates do not consider the effects of financing. Depending on the cost of debt (interest rate), financing has the ability to lower or increase an investment’s internal rate of return.
- Cap rates do not consider the tax impact of real estate ownership. There are a number of tax benefits to real estate ownership which lower taxable income and increase returns.
- Direct capitalization only looks at a one-year forecast to determine value. It does not take into account changes in periodic cashflows or property value over the life of the investment.
- The value of an investment can be distorted if the net operating income does not represent a stabilized NOI. Properties are considered stabilized once they are fully leased or have achieved reasonable occupancy based on market vacancy rates.
While they have their limitations, cap rates can provide useful information about real estate market values because they indicate how much an investor will pay for each dollar of net operating income. In general, markets defined by rising cap rates will see a decrease in property values and vice versa.
Investors are primarily concerned with a return on their investment. The required return must be commensurate with the risk associated with said investment. Investors can thus compare different investments based on their risk profiles and associated yields. The riskier the investment the greater the required return.
Historically, stocks and bonds were the two major investment asset classes, but today real estate aggressively competes for investor dollars in the capital market. Commercial real estate has investment behavior attributes similar to both the bond and stock market. Contract leases are like bonds while the upside realized by re-tenanting and/or repositioning a property resembles stocks. As a result, the risk and returns associated with unleveraged, institutional commercial real estate generally fall between that of stocks and bonds.
Despite their similarities, real estate tends to be impacted by different economic events than stocks and bonds. Notably, real estate can be a sound investment during inflationary periods. Increases in market rents may occur more quickly than increases in operating expenses leading to a rise in net operating income. Demand for such assets places downward pressure on capitalization rates leading to an increase in value.
Because the returns for real estate are not highly correlated with that of stocks and bonds, it becomes a crucial part of any portfolio as a means of reducing overall risk.
I like real estate as an investment because at the end of the day it is real. You can touch it and it has intrinsic value. An investor can directly influence the performance of their investment through effective property/asset management, discretionary capital improvements, etc. Finally, real estate is the only investment class where obtaining and acting on information that is not publicly known is not only legal, it’s often the foundation of a good deal.
Commercial real estate should be a part of any well diversified investment portfolio, but particularly during inflationary periods. Here are four reasons why commercial real estate is an excellent hedge against inflation:
- Most commercial leases include annual rental escalations. These escalations can be a set amount or can explicitly be tied to inflation indexes such as the Consumer Price Index (CPI).
- Even without annual rental increases, rental rates are subject to adjustment/renegotiation at the expiration of the lease term. In most cases, rental rates will have increased to meet inflation.
- Expenses to operate the property (CAM, taxes, insurance, etc.) are generally passed along to tenants. Therefore, owners are not directly affected by the inflationary increases in these costs.
- Higher construction costs resulting from inflation reduce commercial development allowing demand to catch up to supply thus leading to an increase in market rents.
The ability of commercial rents to keep pace with inflation coupled with protections against increases in expenses associated with ownership allow net operating income (NOI) to increase in an inflationary environment. As new development stagnates and the market moves closer to equilibrium, there is also downward pressure on acquisition cap rates which further increases property values.
Gross Operating Income – Expenses = Net Operating Income
Value = NOI/acquisition cap rate