What is Cap Rate Expansion?
Cap Rate Expansion refers to the scenario in which the capitalization rate of real estate assets such as properties collectively rise.
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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.
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)
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.