The cap rate is one of the most basic calculations that investors often utilize when assessing both a property’s value, and its current rate of return on investment. This figure represents a property’s net annual income divided by the purchase price, and for many investors it represents the starting point in determining whether or not a particular property should even be considered for purchase.
In hot real estate markets, cap rates tend to be driven down, as investment money is easier to come by, lenders are making more favorable financing terms available to buyers, and the buyers themselves tend to be doing better economically, being flush with more cash and wanting to invest it in more property. So all of these factors combined create an overall greater demand for property, causing sellers to command higher prices, thereby driving down the overall cap rates.
But in hot commercial real estate markets, particularly in those markets that experience substantial appreciation in property values, the cap rates can get driven down even further. In specific areas within states like California, New York, and Florida, for example, the appreciation rate can be 20-30% per year on property, and this can then create a frenetic demand for buyers to own more property. The idea here is that with the huge amount of annual appreciation that’s been going on, the cap rate is now less significant, and the big money to be made is now in the annual appreciation. So in markets like these, the cap rates can get driven down to maybe 3-4%, then when you add this to the 20-30% annual appreciation rate that’s been going on, the overall annual returns can become quite substantial.
Now contrast this instead with a market where even in a good economy, it’s been experiencing just a 3-5% annual appreciation rate on property values, and when doing so we begin to understand just how much higher the cap rates now need to be in these areas in order to attract buyers. So in this situation, a buyer may demand an 8-10% cap rate, because they’ll be experiencing so much less in annual appreciation.
But in the hot markets, once the great annual appreciation rate finally subsides, and buyers are looking at just a 3-4% cap rate on a property with no annual appreciation, their interest in buying the property can then wane very quickly. However, the sellers can oftentimes then believe that their property should still sell at the 3-4% cap rate, and they just don’t understand how the market dynamics have now completely changed on them.
So, in putting this together, whether you are a buyer or a seller, timing is critical, and you need to understand when to get in at the right time, and when to sell at the right time, too.
