Prospective real estate investors must take a wide range of factors into account when determining if an investment opportunity is worth the risk.
A property’s location and the trajectory of its immediate surroundings - population growth, crime rates, quality of schools, access to transportation, etc. - are the most fundamental traits to evaluate. Other structural factors, such as a building’s condition and the costs to renovate for value-add opportunities, must also be considered. On the financial side, investors have to think about the cost of debt, capital structure, and the investment horizon for each opportunity.
Taking stock of all the factors above is still just scratching the surface for making an ultimate determination. Evaluating properties can be complex, and usually deciding to invest in a property or pass on it is not a straightforward decision.
On the latest episode of Cadre’s Real Estate of Mind podcast, Cadre Founder, CEO and Executive Chairman Ryan Williams was joined by Cadre Chief Investment Office Dan Rosenbloom. Together, they discussed commercial real estate investment strategy, from both a macro and micro lens. Dan talked through some of the factors that guide Cadre’s thesis for investment decisions, as well as some specific investments he’s been involved in throughout his career.
One of the most prominent factors in the conversation was cap rates. This blog will take a closer look at the metric and why cap rates are so crucial for forming investment decisions.
At the most basic level, the cap rate is determined by taking the net operating income (NOI) of an asset and dividing that by its cost, or market value. This rate is then expressed as a percentage.
Cap rates do not stay static over time; they either compress or expand. Generally speaking, a lower cap rate indicates a higher value, while a higher rate suggests greater risk.
Cap rates are powerful tools for real estate evaluators and prospective investors. For instance, they’re inflation-adjusted, so investors can focus on returns without worrying about inflation modifications. They also provide a uniform metric for efficiently determining the perceived value of an asset and for quickly comparing properties. Finally, cap rates inform a comprehensive overview of assets at both the property and market levels.
To fully understand cap rates and their usefulness for evaluating properties, it’s important to grasp why these rates may move up or down. If the numerator of the cap rate shifts, this means that the net operating income of the asset is changing. Typically, this means that rent collections or occupancy rates are in flux. Oftentimes, the more significant cap rate fluctuation is denominator-driven. These denominator changes indicate movement in the asset’s real or perceived value. Investors must be sharply attuned to asset values at all times lest they change too rapidly.
Once investors understand cap rates and how they move, they can start to apply that knowledge. To become fully fluent in working with cap rates, it’s important to understand how to interpret their meaning at a national, market, and asset level.
Investment volume in commercial properties declined1 for the first time since the pandemic in the back half of 2022 and into the start of this year. At the surface level, cap rates may not appear to explain the dropoff. The difference between cap rates in 2019 and today is largely flat2; a bit higher than what they were in 2019 but not significantly so.
Upon a closer look, we gain a more comprehensive view of the CRE environment. Commercial properties have experienced drops in average operating income and market value, impacting both the numerator and denominator of the cap rate equation. Given the impact of interest rates on operating expenses, cost of debt, and downward pressure on revenue growth, we can explain the muted expansion in cap rates.
For investors to feel greater confidence in national market conditions, cap rates would need to experience a more dramatic shift. That could mean assets mark to market and begin to trade more frequently, ultimately raising values – or, inversely operating income growing to push cap rates higher. Only then could investors expect to project similar absolute returns commensurate with the pre-pandemic market.
Accurately projecting cap rates at the market level can be an incredibly powerful tool for making an investment in a location of interest.
Current cap rate metrics for any given market can be easily researched, but projecting how the market will develop can be a crucial differentiator. It’s not a simple task, and investors who know a given market well gain a massive advantage. Another way to generate trustworthy projections is by building relationships with operators in specific markets. In the most ideal partnerships, these operators have years of experience investing in a particular market, with a track record of proven results.
With this type of market analysis, predicting a future hotspot for growth is the best case scenario. Being ahead on a market like Charleston or Raleigh years ago certainly has paid off for some who saw a population explosion coming.
But edges can be found even in better-known markets. Take Austin, Texas as an example. Austin has been a hot market for a long time, seeing steady gains in population growth that rapidly accelerated during the pandemic. This population swell helped propel a cap rate expansion in Austin, with upticks in rental income and property prices safely projectable.
Still, Cadre’s knowledge of the market and proprietary forecasting model suggested market growth would have a longer tail than most projections predicted. Seeing that there was still value beyond Austin’s already-optimistic forecasts, Cadre ultimately decided to invest in a property in the area.
Ultimately, discerning investors make decisions at the asset level, looking beyond macro and market noise.
Prior to the pandemic, Cadre invested in a Nashville-based asset. The investment was underwritten with a particular cap rate, and the team had plans for major renovations and expansion for the site. Fortunately, in accordance with team policy, Cadre projected a conservative exit cap. Despite the drastically different environment following the onset of COVID-19, the conservative exit cap and underlying value of the asset gave the team room to change its business plan, secure an attractive partial sale of the asset, and renegotiate lending terms.
While the COVID outbreak was a once-in-a-century type of market disruptor, it illustrated the importance of preparing for challenging scenarios and understanding all the existing opportunities and risks in a given asset.
For more practical information about how cap rates can be digested and applied, listen to episode two of Cadre’s Real Estate of Mind podcast. Dan shares some specific examples of how cap rates guided his investment decisions, and Ryan provides a detailed overview of how to approach cap rate analysis.
Cadre’s newest fund, the Direct Access Fund II, uses data from proprietary forecasting models that capture and anticipate cap rate movement to inform investment decisions. The fund will provide investors with access to mid-cap investment opportunities across multifamily, industrial, office, and hotels. Contact our team to hear more about our data, opportunities, and important disclosures today.
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