When do cap rates change?

[Jay Pillalamarri]

Hey guys, I wanted to ask the experienced MF investors the following (from an economic cycle standpoint)-

1. When does the cap rate of a local neighborhood/market change? What are the economic factors which affects the cap rates?
2. How fast/slowly does it change?
3. How do you factor that into your investment strategy (2-5 year strategy)? E.g. If you are buying in low cap rate markets and foresee that they can increase (thus bringing down the value of your asset)...what do you do?

[Brian Burke]

@Jay Pillalamarri there is only one factor that influences market cap rate:  supply and demand.

When demand is high, investors are forced to bid against one another, driving prices up and cap rates down.  

When demand is low, prices fall which means that cap rates rise.

So the real question is what influences demand?  There are many factors.  Interest rates.  Return on investment thrown off from other investments carrying similar risk.  Fear.  Greed.  Rumored or known neighborhood revitalization or economic development. Overall economic strength or weakness.  Heck this list could go on and on and on.

How fast or slow does it change?  Values could rise or fall tremendously in an instant  so there is no standard here.  Imagine if you were in a sleepy 10 cap market that’s been dead for decades and Amazon suddenly announced they were moving their headquarters there. Cap rates would move quickly and by a lot. Or if you were in a great market that was humming along with low cap rates and then there was an accident at the nuclear power plant and the population started moving as far out of town as they could. But generally the good news is that real estate isn’t like stocks and commodities, you don’t have to turn on the TV every morning to find out if you are rich or poor.  It tends to move somewhat slowly most of the time.

How do I factor cap rate into my investment plan?  I expect that caps will rise, and I underwrite to a higher exit cap than is market today. There is a huge demand for real estate now so to assume that there will be just as much, or even more, in the future strikes me as overly optimistic.