One of the most important valuation metrics in real estate is the capitalization rate, or “cap rate” for short. There are many ways industrial investors can use cap rates, from valuing properties to determining which building improvements will result in the greatest returns. Investors have differing opinions on whether a low cap rate is a good thing or not. Many institutional investors with long-term, patient capital will opt to buy properties at a low cap rate as these are generally well-located and fully stabilized assets. However, low cap rates can translate into lower returns—a turnoff for industrial investors seeking higher yields. In this article, we look at the benefits to investing in a low cap rate market like we’re in today. As you’ll see, there is still significant opportunity to increase value even in a low-cap rate environment.
What is Cap Rate?
The capitalization rate, or cap rate, is basically the inverse of the price earnings (or PE ratio) that is commonly used to value stocks. Cap rate is calculated as follows:
Cap Rate = Net Operating Income (NOI) / Property Value
For example, if a warehouse property is generating $1 million of NOI in a five-cap (5%) rate market, that asset would be valued around $20 million. In a four-cap (4%) rate market, that same warehouse generating that same cash flow would be worth an estimated $25 million.
In order for the spread to increase on real estate investments, one of two things must happen: either NOI needs to increase or the property value needs to decrease. Typically, it’s the latter.
What Factors Influence Cap Rates? There are a lot of factors that influence cap rates and collectively, these tend to fall into three categories:
1. Capital Markets. The availability and cost of capital has arguably the largest impact on industrial cap rates. In a low interest rate environment, buyers are often willing to spend more on an asset which in turn, drives down the cap rate. As interest rates rise, cap rates tend to follow suit.
This is because investors start to compare real estate returns to other asset classes. Virtually every investment is ultimately tied to a risk premium over a risk-free rate. The standard “risk free” rate is U.S. treasuries. So if the cost of U.S. treasuries goes up, money will flow there unless the returns offered by other investments rise as well. This is how the risk premium is maintained.
In real estate, there is always discussion of the spread between U.S. treasures and cap rates. That spread can expand or contract at different stages of a cycle, which is what we’re seeing today. In order for the spread to increase on real estate investments, one of two things must happen: either NOI needs to increase or the property value needs to decrease. Typically, it’s the latter.
There are several things that can impact an asset’s growth expectations. For example, supply and demand in marketplace can play a role, as can the product type. A warehouse may have competitive attributes that make it worth more than other nearby warehouses.
2. Cash Flow Growth Expectations. As noted above, NOI also influences industrial cap rates. The extent to which an asset can generate additional cash flow will also impact its value.
There are several things that can impact an asset’s growth expectations. For example, supply and demand in marketplace can play a role, as can the product type. A warehouse may have competitive attributes (e.g., strategic location, multiple loading docks) that make it worth more than other nearby warehouses.
3. Risk Factors. Properties are also subject to various risk factors that can influence their value. An individual asset may have competitive weaknesses—for example, insufficient parking or lower ceiling heights. Structural forces can also impact value. Just look at what Amazon has done to Main Street retail. The “Amazon effect” has had a detrimental impact on retail, but has been a boon for industrial property. Structural forces like these have impacted some property types more so than others.
Should We Be Afraid of Low Cap Rates?
Low cap rates are not inherently good or bad. It really comes down to both a) understanding what’s driving an asset’s cap rate; and b) an individual’s investment objectives.
For example, some industrial investors are afraid of low cap rates. They believe low cap rates limit their cash flow and puts their upside potential at risk.
In some markets, and with some business strategies, that’s a legitimate fear. Consider an investor who buys an asset in a low cap rate market that has significant supply-side risk. This might be a Sunbelt city where there is a lot of affordable, developable land nearby. It might be in a municipality where there are few regulatory barriers to new construction. Existing assets are therefore not price at a large discount to replacement cost.
In a situation like this, new industrial supply might limit the growth of (or even reduce) operating cash flow and thus, the asset’s appreciation potential. In turn, the cap rates on existing prices will rise given fears over lower rent growth expectations and higher perceived risk.
Similarly, someone who buys a stabilized asset in a low-cap rate market must be extremely confident that everything works in their favor. Debt must be readily accessible at low rates; rent growth must continue as anticipated during the underwriting process; and the potential risks never materialize. Otherwise, cap rates will inevitably rise and industrial values will come down accordingly.
This is what exactly what we’re seeing today in many commercial real estate markets. Investors who purchased assets at exorbitantly high prices over the past few years are now feeling the impacts of the market correction.
However, thoughtful value-add investors will find that there are still opportunities to increase revenue even in a low cap rate environment.
Cap Rates are already rising due to higher interest rates and likely will continue to rise through at least mid-2023.
How to Invest in a Low Cap Rate Market For value-add industrial investors, certain low cap rate markets offer an exceptional opportunity—even during times of economic uncertainty.
Here are some of the ways to invest in a low cap rate market:
Look for industrial assets where there is an asymmetrical relationship between risk and reward. These assets offer a combination of significant upside potential (i.e., higher rents and property appreciation) with very little, if any, downside risk during a market downturn.
Invest in regions with strong economies and growing populations. Both factors should be present. For example, some people are drawn to the Sunbelt because of its growing population, but there is not as much economic growth compared to other metro areas (e.g., Los Angeles, Austin, and Miami).
Consider existing supply and barriers to entry. In some regions, it is significantly easier to develop new industrial property than in others. Look for markets where supply is constrained and the barriers to entry are high.
Look for assets with a cost advantage compared to new construction. Many investors will tell you that if you invest in a low cap rate environment, you should be buying assets at a 30-50% discount to replacement costs.
Find assets with a strong “loss to lease” – i.e., the building’s current market rents are below market rate by 30% or more. This allows you to incrementally increase rents, even during a downturn.
Collectively, these competitive advantages provide unparalleled downside protection, especially during market downturns.
While investing in a low cap rate environment can give some investors pause, others will see strategic opportunities. When combined with conservative leverage, value-add industrial investors will find that the returns can be highly attractive.
Will Cap Rates Rise?
Yes, even in some of the strongest markets, we expect cap rates to rise. In fact, they’re already rising due to higher interest rates and likely will continue to rise through at least mid-2023. However, cap rates will rise faster in some markets and among some product types than others. This is why industrial investors must carefully consider what’s driving the cap rate associated with any given deal. That said, even as cap rates rise, there is an opportunity for value-add investors to increase property value. Consider this: for every additional $1 in cash flow, this translates into $20 to $25 in incremental value in a 4 to 5% cap rate market.
The Bottom Line While investing in a low cap rate environment can give some investors pause, others will see strategic opportunities. When combined with conservative leverage, value-add industrial investors will find that the returns can be highly attractive.
About the ComReal Miami Industrial Team: The ComReal Miami Industrial Team has been assisting companies with their South Florida real estate needs for over 30 years. The industrial team specializes in the sales and leasing of industrial properties. Visit Warehouses Market and/or call 786-433-2380 for more information.
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