Cap Rate Expansion

What Causes Cap Rate Expansion?

The occurrence of cap rate expansion can stem from a multitude of factors that cause a shift in the perceived riskiness of real estate investments.

1. Rising Interest Rates → If the market interest rate rises, the cap rate tends to follow suit. The interest rate reflects the cost of borrowing, so a higher interest rate causes investors to demand higher returns to compensate for the incremental rise in the cost of financing.
2. External Factors → External economic factors, such as geopolitical instability or widespread fears of a recession, can contribute to cap rate expansion. In addition, location-specific factors, such as deterioration in the safety of the neighborhood and a downtrend in the output of the local economy, present more risks to investing in the specific market.
3. Supply/Demand Market Dynamics → Given a state of excess supply in the market, investors have more optionality in picking investments, i.e. it is a “buyers’ market”. In effect, property owners and landlords often compete for price, and reduced property values cause cap rates to increase. If the NOI variable is held constant while the property market value declines, the cap rate rises.
4. Reduction in Net Operating Income (NOI) → If the rental income (and thus NOI) of the properties declines – perhaps due to increased vacancy rates and lower rent prices – cap rate expansion can occur. To elaborate, these properties are generating fewer profits from the lower occupancy rates, resulting in a lower expected rate of return (and higher risk).

Cap Rate Expansion Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Cap Rate Expansion Calculation Example

Suppose a commercial real estate (CRE) investor is performing scenario analysis on a potential investment, where the variable being sensitized is the property value.

The investment opportunity, a commercial office building, is expected to generate a NOI of $200k post-stabilization.

• Net Operating Income (NOI) = $200k

The commercial leases are long-term with tenants of high creditworthiness, so the twelve-month forward NOI is held constant throughout all five scenarios to isolate the property purchase price.

While the scenario deviates from reality, the assumption is intended to control the variables and better illustrate the conceptual relationship between net operating income (NOI) and market cap rate.

The purchase price, or property value, is $2 million in Scenario A, and we’ll use a step function to reduce the purchase price by $100k in each subsequent scenario.

• Scenario A – Property Value = $2.0 million
• Scenario B – Property Value = $1.9 million
• Scenario C – Property Value = $1.8 million
• Scenario D – Property Value = $1.7 million
• Scenario E – Property Value = $1.6 million

For each scenario, the NOI of the property is divided by the corresponding property value to determine the implied cap rate.

• Scenario A – Cap Rate (%) = $200k ÷ $2.0 million = 10.0%
• Scenario B – Cap Rate (%) = $200k ÷ $1.9 million = 10.5%
• Scenario C – Cap Rate (%) = $200k ÷ $1.8 million = 11.1%
• Scenario D – Cap Rate (%) = $200k ÷ $1.7 million = 11.8%
• Scenario E – Cap Rate (%) = $200k ÷ $1.6 million = 12.5%

After computing the cap rates under the five scenarios, we’ll back-solve the property value using the income approach (i.e. the direct capitalization method).

After inputting our assumptions from the earlier section into the property value formula, the relationship between the property value of the commercial office building and the market cap rate can be illustrated, where a higher cap rate causes the property value to decline.