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Real estate investors often refer to a cap rate. Can you tell me what a CAP RATE is, and how it is calculated?
What is the cap rate? In CRE it is the rate of return expected to be generated on an investment property. Cap rate = Net Operating Income (NOI) / Current Market Value (Purchase Price).
If NOI is $100,000 and it is purchased for $1 million, then the cap rate is 10 per cent.
When interest rates are low, cap rates are also low. With low interest rates, servicing larger debt requires less income – i.e. is “cheaper”. More cheap credit = more cash to buy. Due to demand, prices for CRE increase and cap rates decrease.
How are cap rates influenced by inflation? Cap rates follow real interest rates. Real interest rate = nominal interest minus inflation. E.g. nominal rate 5% – inflation 6% = real interest rate is -1%.
High inflation = cap rates decrease and property prices increase.
If real interest rates are lower, why do we see the CRE market expecting higher cap rates these days?
– CRE has long-term leases and fixed NOI. Real ROI drops with higher cost of servicing debt and fixed NOI.
– Buyers’ expectations of more nominal interest rate hikes and taming of inflation.
Values of CRE are not immediately reflected because they are typically based on income. And commercial leases are typically long-term.
What does this mean for real estate?
The housing sector is a consumption good, part of final demand. But commercial real estate (CRE) adds to production on the supply side of the economy.CRE is also considered a capital asset. Much like stocks and bonds, CRE is often found on the balance sheets of institutional investors and banks.
This means CRE helps add to employment and GDP. It is vital to economic recovery.
The housing sector responds faster to rate hikes. Canadian home prices declined since last year for this reason.
Many multifamily housing projects are being put on hold and this will impact the construction cycle. Yet people need housing and countries like Canada are in great demand for immigration. We've just hit a new record yesterday in population growth.
How about the impact on CRE?
CRE has a smaller share of the market than housing, representing perhaps 1/3 and housing 2/3.
CRE also tends to be less directly related to the general macro-economic business cycle. Analysis of it is more complicated.
But if I had to sum it all up...
As long as inflation is higher than nominal interest rates, expect real property value to go up. And remember that there is a delay because lease rates are not immediately adjusted. And it assumes the world doesn't implode with bank failures...