Who determines the Cap?

Question

People say Cap Rates are the function of investor's appetite. If they are willing to pay less for NOI, Cap will go up.

What about the tenants on the other hand? If they decide that 1000$ for studio is too expensive, and they can't afford it based on economics they can make the prices to go down. That will decrease our NOI, and Cap will also go up.

So, is Cap really a representation of investors appetite or D&S of rental housing? Or maybe it's a combination of both?

Jaysen Medhurst · Answer

@Vlad Denisov, Cap Rates are essentially "the market" when it comes to commercial real estate. They are a reflection of demand, risk tolerance, expected returns, etc. of the investors, not the tenants. Of course, supply and demand of the tenants drives rental prices, but not in the way you're suggesting above.

Tenants as a group don't decide that $1k is too expensive and all of a sudden every studio in town is empty. Instead, owners are constantly nudging rents to see what the market will bear. So a few studios may get listed for $1k and not get leased up, the owners lower to $950 and get  tenants. The owners didn't "lose" $50/month, so that doesn't change the NOI. In fact, if a studio was renting for $900, the NOI is still improved, just not as much as it could have been.

There are, in fact, very few markets where rents decline...ever (of course there are exceptions). A bit of a blip during the financial crisis in very expensive areas (I watched it happen in Manhattan), but that quickly corrected itself as it had more to do with the over-heated market leading up to it.

In most areas rents were flat or actually went up. Why? People were losing their homes and had to go somewhere, which increased demand for rentals. When I moved from Central CT in 2004 I was paying $600/month for a large 1 bd. A similar apartment there now rents for $900+. A 50% increase in 15 years. Not stellar rent growth compared to other markets, but that town's housing prices are just starting to get back to the pre-crash highs. So, rents = 50%+, housing prices = flat.

Bill Goodland · Answer

Agree with as stated above. Another way to put it is that the cap is the return that the market is willing to accept for a particular asset. For assets in high demand markets, investors are willing to take a lower return. When there is more competition in a market, investors compete and are willing to accept less of a return to buy a particular property and thus drive up values. For example, some high rise multifamily apartments in A+ locations in manhattan may go for a "2-3 cap" or a 2-3% return if the property was bought all cash. Whereas a mobile home park in the middle of nowhere may go for a 12 cap because investors require a higher return for something that is much more management intensive with less appreciation potential.

One might assume that a higher cap rate is always a good thing, however, if your business plan is to force appreciation by improving NOI, a lower cap rate multiplies the value of the improvements you made more than a lower cap rate based on the simple math of it. NOI/Cap rate = Value.

Chase Louderback · Answer

Cap rate is solely determined by the market.  Investor's appetite for risk and acceptance of lower returns will drive cap rates lower (increase the market value of the property with same NOI).  If tenants for a specific property move out, it will not effect the market cap rate but only the value of that particular property because of the decrease in NOI.

Theo Hicks · Answer

For commercial multifamily properties, the cap rate and the NOI determine the value. Not many investors base their investment decisions on the cap rate.

The return metric that is important to you is based on your goals. If you're goal is cash flow, then cash-on-cash return is your metric. If you are raising capital, IRR is likely your metric. If you are fix and flipper, the ARV is your metric.

John Corey · Answer

@Vlad,

The market determines the CAP rate. Vacancies and similar are ingredients to the NOI.

The CAP is relative to alternatives. Government bond interest rates are the zero risk, zero hassle, liquid alternative. So, an investor will only look at RE investments if they receive a better CAP rate than a bond.

Greg Dickerson · Answer

@Vlad Denisov  CAP Rates are how properties are valued in certain markets for different classes and types of commercial real estate. If the NOI drops that will not affect the cap rate only the overall value of the property.

Account Closed · Answer

The cap, short for capitalization rate, is a measurement of the return of investment. There are many ways to analyze an investment, and the cap rate is simply one of them. There is also more than one way to think about the cap rate.

Who determines the cap? Buyers determine the cap rate, by way of paying more or less for property. As a buyer pays less the cap rate goes up, and as they pay more the cap rate goes down. This is because many (most) property expenses are fixed, while the amount a buyer might pay is variable. It's not rocket science, but it does require an accurate accounting of expenses to calculate.

When figuring out the market cap rate, this is simply a measurement of what other buyers in the market typically pay for and receive.

You will decide for yourself what works for you, you will act on that, and your decision, combined with all the other decisions of other buyers, will result in the market cap rate.

Make sense?

Vlad Denisov · Answer

Great article, thank you.

Josh Oaten · Answer

@Vlad Denisov

Like what has been mentioned, the Cap Rate is just a representation to compare properties in a market at that time. This issue with Cap Rate for a value add investor like me is that it is pointless. Cap Rate measures and all cash purpose, which many investors don't do. Like I said, its a measure of returns at that specific point in time, but thats no used to me because I am going to reposition and increase its revenue. I could buy a 2% Cap property and increase it to a 4% cap over 3-5 years and make a healthy return, no different to taking a 10%cap to a 12%cap over 3-5 years.

This article by @Omar Khan will clear this up for you more.

https://www.biggerpockets.com/member-blogs/10776/77428-the-cap-rate-is-dead-long-live-the-cap-rate

Who determines the Cap?

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