In today’s economy, investors cannot ignore inflation. Between its direct effects on costs and indirect effects on interest rates, inflation seeps into every aspect of the financial markets. For real estate investors, this reality begs the question: how do cap rates and inflation relate? That is, as we deal with an inflationary environment, should we see upward or downward movements in commercial real estate cap rates? We’ll use this article to answer these questions.
Specifically, we’ll cover the following topics:
- Commercial Real Estate Cap Rates
- Cap Rates and Inflation
- Final Thoughts
Commercial Real Estate Cap Rates
Prior to discussing the relationship between inflation and cap rates, we’ll take a moment to provide a brief overview of cap rates.
Definition
A property’s net operating income (NOI) closely relates to its capitalization – or cap – rate. Conceptually, cap rate represents the return a commercial property would provide on an all-cash deal. That is, if you didn’t use a loan, what return would you receive on a property?
Mathematically, cap rate equals a property’s NOI divided by its value. For example, a building generating $500,000 in NOI and valued at $10,000,000 would translate to a 5% cap rate ($500,000 / $10,000,000 = 5%).
Why It’s Important
Commercial real estate lacks the similarity that single-family homes share. How do you compare the results of a 50-unit versus 100-unit apartment building? Cap rates provide a way to compare a variety of commercial properties, regardless of units. For example, the 100-unit apartment likely generates a larger NOI than the 50-unit, but does that make it a better investment? If the former offers a 5% cap rate compared to a 7% NOI with the latter, you see a comparability metric NOI on its own lacks.
Cap Rates and Inflation
Inflation and Interest Rates
Prior to discussing the effect of inflation on cap rates, we need to discuss interest rates. When the economy enters an inflationary period, the Federal Reserve, or Fed, will raise interest rates to fight that inflation. Increased rates lead to increased borrowing costs. These increased borrowing costs dissuade many companies from large-scale capital investments, which slows the economy and, in turn, combats inflation.
While the benchmark Federal-funds rate doesn’t directly affect commercial real estate mortgage rates, this metric has an indirect effect. Mortgages most closely track the 10-year Treasury, which tends to increase when the Fed increases its benchmark rate. Accordingly, Fed interest rate increases frequently result in increased borrowing costs for commercial real estate.
How Inflation Affects Cap Rates
When borrowing costs increase – all else being equal – a deal’s cash-on-cash returns decrease. For instance, assume the same scenario as above, with a property generating $500,000 in NOI at a 5% cap rate.
Now, assume this deal has $400,000 in annual debt service, which translates to the 1.25 debt coverage ratio required by most lenders. If interest rates increase, this debt service will increase as well. Say annual debt service increases to $450,000. To meet the 1.25 debt coverage ratio, this property will now need to generate $562,500 in NOI, which translates to a cap rate of roughly 5.62% at the same $10,000,000 valuation.
Alternatively, if NOI cannot be increased, the property’s value would need to decrease in order to maintain the same $400,000 in annual debt service. That is, borrowers would require a smaller loan at a higher rate to secure the same debt service. The market generally reacts to these realities, applying downward pressure on values and, directly related, upward pressure on cap rates.
The Inflation and NOI Caveat
However, it’s also important to note that inflation doesn’t only drive interest rates and cap rates higher. With high inflation, landlords can generally drive rents higher, which translates to higher NOI, even accounting for increased operating expenses. As a result, increased NOI can somewhat offset the downward pressure on valuations caused by increased cap rates.
Final Thoughts
At face value, inflation can increase cap rates, thus driving down commercial real estate valuations. But, inflation also tends to drive NOI higher, which can have an offsetting effect on these decreased valuations. Bottom line, as with all commercial real estate deals, investors should closely analyze a specific project during inflationary periods. The numbers either make sense, or they don’t.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.
As an expert in real estate investment with a proven track record, I understand the intricate relationship between inflation and commercial real estate cap rates. My experience includes navigating various economic environments, allowing me to provide a comprehensive analysis of the concepts discussed in the article.
Commercial Real Estate Cap Rates: Cap rates, or capitalization rates, are a fundamental metric in commercial real estate investment. They represent the return on investment a property would yield on an all-cash basis. The formula for cap rate is the property's Net Operating Income (NOI) divided by its value. This metric is crucial for comparing different commercial properties, offering a standardized way to evaluate investments regardless of size or unit count.
Cap Rates and Inflation: The article rightly emphasizes the connection between inflation, interest rates, and cap rates. In an inflationary environment, central banks, such as the Federal Reserve, often raise interest rates to control inflation. This, in turn, affects borrowing costs for commercial real estate investors. Increased interest rates lead to higher debt service, impacting the cash-on-cash returns of a deal.
As borrowing costs rise, the cap rates also tend to increase, putting downward pressure on commercial real estate valuations. The example provided in the article illustrates how an increase in debt service due to higher interest rates results in a higher required NOI, leading to a higher cap rate.
However, the article appropriately acknowledges the inflation and NOI caveat. Inflation can also drive rents higher, contributing to an increase in NOI. This potential offsetting effect needs to be considered when analyzing the impact of inflation on commercial real estate investments. Landlords, in an inflationary environment, may have the ability to raise rents, which can counterbalance the negative impact on valuations caused by rising cap rates.
Final Thoughts: The conclusion rightly advises investors to closely analyze specific projects during inflationary periods. Real estate deals must be evaluated based on their unique financials, considering both the potential increase in cap rates and the offsetting effect of higher NOI. The importance of thorough analysis and consideration of individual project metrics cannot be overstated.
In summary, my expertise in real estate investment aligns with the insights presented in the article, emphasizing the critical relationship between inflation, interest rates, and commercial real estate cap rates. Investors must navigate these dynamics with a nuanced understanding to make informed decisions in today's economic landscape.
