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Cap Rate Expansion

Step-by-Step Guide to Understanding Cap Rate Expansion

Last Updated March 6, 2024

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Cap Rate Expansion

How Does Cap Rate Expansion Work?

Cap rate expansion reflects the current sentiment in a particular real estate market regarding the collective risk-return profile of the properties in that location.

The capitalization rate, or “cap rate”, is a method used to evaluate the potential yield received on a property investment in real estate.

Cap Rate (%) = Net Operating Income (NOI) ÷ Property Value

Where:

  • Net Operating Income (NOI) → The sum of a property’s rental income and ancillary income, subtracted by direct operating expenses.
  • Property Value → The fair market value (FMV) of a particular property as of the present date.

If the market cap rate rises, investors are pricing in more risk to invest in a specific segment of income-producing real estate assets, such as properties.

  • Cap Rate Expansion → Lower Property Prices (More Risk)
  • Cap Rate Compression → Higher Property Prices (Less Risk)

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How Does Cap Rate Expansion Impact Property Value?

To further expand on the prior section, there is an inverse relationship between cap rates and property values.

Since cap rate expansion coincides with higher cap rates, property values in the given market should be expected to decline.

Why? The consensus in the market is that these properties carry more risk, resulting in a reduction in property prices.

Given the upward trajectory in perceived risk, investors in the market will demand a higher return, which is achieved via reduced pricing for the properties.

From the perspective of an investor, a lower purchase price improves the odds of achieving a higher return (and vice versa).

Therefore, rising cap rates in a particular real estate asset class or location cause the market values of the assets to decline, because the investments are assumed to be riskier (or less attractive opportunities).

Note: As usual, there can be exceptions to the rule, where property values do not decline amid cap rate expansion, which often coincides with limited supply, abundance of demand, and increased risk appetite among investors.

Cap Rate Expansion vs. Cap Rate Compression: What is the Difference?

The directional shift in cap rates can be categorized as either cap rate expansion or cap rate compression, which are contrasting movements in the capitalization rate, i.e. changes in perceived risk and value ascribed to income-producing properties.

  • Cap Rate Expansion → The capitalization rate in a particular real estate asset class or segment rises, reflecting higher perceived risk among investors.
  • Cap Rate Compression → The capitalization rate in a specific real estate asset class or segment declines, signifying the perception among those in the market that the investments are now less risky.

In short, the outcome of cap rate expansion is reduced property values, while cap rate compression results in higher property values.

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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).

Property Value = Net Operating Income (NOI) ÷ Market Cap Rate (%)

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.

Cap Rate Expansion Calculator

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