CAP rates in rising interest rate environment

[Tyler Todhunter]

Hi all,

I am a small investor, currently with (2) 4-plexes and a SFR. I am lining my finances up to be able to purchase something larger, but with yesterdays Fed rate hike, I have a concern with commercial multifamily investing. As rates rise, investors want a higher rate of return- typically. By layman's logic, this would cause CAP rates to rise. With commercial properties priced according to CAP rates, is one setting themselves up for a losing proposition? A property purchased with a $100k NOI at a 5% CAP puts the price at $2,000,000 acquisition. If investors, in a year, demand a 6% CAP, value of the property would reduce to $1.66m for a loss of $333k. Of course, rents theoretically would increase with inflation to, perhaps, $110,000- this would still result in a loss of $167k.

CBRE is showing CAP rates trending down, at least through Q4 2021- which seems counterintuitive. Are there more market forces at play which may keep CAP rates at or around where they are currently? Or is it wise to wait for increased CAP rates to put money to better use?

I'm interested to hear your thoughts in these "unprecedented" times. “History doesn't repeat itself, but it does rhyme.” - Mark Twain

[Brian Burke]

@Tyler Todhunter using your own example where the $100K NOI went up to $110,000, that's assuming roughly 5% rent growth (assuming expenses make up about 50% of the rents it would take 5% rent growth to increase NOI by 10%). So you're right--if you buy a commercial multifamily property, and cap rates go from 5% to 6%, and rents grew 5%, and you sold in one year, you'd lose money.

But if you hold for one more year, and rents go up another 5% (increasing NOI by 10%), your NOI is $121,000 (I'm over-simplifying, but this is close). At a 6% cap rate you're back to your $2MM price. So just don't sell in a year.

But what if rents grew 10%?  Or, as we have seen in some markets like Phoenix, Tampa, and Atlanta, rents grow by 15% or even more?  Some markets are forecasted to increase at that rate over the coming quarters--this is why people are buying at such low cap rates, even with the threat that cap rates decompress somewhat.

Eventually someone is going to lose this bet.  The ten million dollar question is, "when?"