Cap rate compression

[Nicholas Burch]

Help me understand Cap rate compression. I've heard many different iterations of this strategy and I am starting to think this is a make-belief concept. From what I understand, a higher cap rate indicates the expected returns from a property harbor more risk, which means investors will pay less for the property. On the other hand, a lower cap rate represents a less risky property, and the investor will be more willing to pay above the property value to receive a lower yield. I know that this is far more than a evaluation of risk and there are more factors to consider than the correlation I've stated. What are your thoughts?

[Evan Polaski]

@Nicholas Burch, I wouldn't call cap rate compression a "strategy", because as Henry noted all cap rate is is math or an unleveraged yield. There are also at least 3 cap rates for any given property: current based on T12, in-place based on some modifications of T12 (i.e. using your anticipated real estate tax amount vs seller), and stabilized. Then you can make modifications to your NOI by say, deferring maintenance items and/or pushing them into Capex, not charging the property your mileage or travel costs for a bit.

It is also not a strategy, for the same reasons you note a lot goes into it and Ronald outlines some way to influence a buyers perception of the risk.  Interest rates going up or down move cap rates a lot, and no one has any real control over that.  

At the end of the day, I see cap rates mainly as driven by demand.  Interest movements affect demand.  Multiple offers and price wars are all driven by high demand.  There are times of high demand and times of low demand.  Again, you can't control this, so I would not call cap rate compression a strategy.

The only time it is a "strategy" is if you are modeling it to boost returns to sell the deal to otherwise fairly unsophisticated investors.  As an LP myself, there are groups that do this and try to defend it if asked about that assumption.  For me personally, if I see that, it is an immediate "trash" on that offering memo.