As a real-estate investor, it's essential to understand the factors that impact cap rates drastically. A cap rate, short for the capitalization rate, is the ratio that measures the rate of return on an investment property based on its net operating income and purchase price. While this number is central to assessing an investment property, it's essential to look beyond just the numbers to assess the long-term prospects of a project. Here, we'll outline the critical factors that affect cap rates, supported by market data, historical trends, and industry professional opinions.

The first factor that significantly impacts the cap rate is market trends. Typically, the cap rate varies from region to region and reflects real estate trends, such as supply and demand levels, economic growth, job growth, and interest rates. According to a report by CBRE, the average cap rate for the multifamily market was 5.8% in Q3 2021, while the retail market had an average cap rate of 6.6%.

One of the biggest drivers of cap rates is interest rates. When interest rates are low, cap rates tend to be lower as well since investors can get better returns in other financial markets. Conversely, when interest rates are high, cap rates will typically rise since real estate investments become more attractive.

Inflation is another major factor that can influence cap rates. If inflation is high, property values will increase, and cap rates may fall because assets are generating more value. The opposite is true when inflation is low – cap rates tend to be higher as investors may be seeking other investment opportunities that offer higher returns.

Government decisions on taxations and subsidies can also have an impact on cap rates. Tax incentives can encourage investments and increase demand, thus driving cap rates down. Conversely, new taxes or higher property taxes can negatively affect the market, reducing demand and driving cap rates up.

In most cases, property cap rates are significantly higher than the interest or yield offered by low-risk assets, as real estate is a comparatively risky industry. At the same time, cap rates tend to be moderately higher than non-investment grade bond yields, for the same reasons. Importantly, spreads are much narrower now than in the past, as interest rates on most bonds have significantly increased these past few months, while real estate cap rates have only moderately increased. Cap rates went tumbling down when rates were slashed in 2020, but have seen much more modest increases once rates started to trend upwards.

In general, investors evaluate location based on three factors – demographics, traffic patterns, and accessibility – and other economic growth factors. The demographics of an area are crucial in determining the type of commercial property to invest in. For instance, regions with large and growing numbers of young professionals may warrant more investments in retail and mixed-use assets, while areas with an aging population may merit investments in medical facilities.

An important traffic pattern is the volume of traffic and the direction of traffic flow. A location with high consumer traffic, such as a central business district, is usually attractive to many investors. An easy and frequent transport network, such as access to rail, shipping ports, and airports, is generally attractive to tenants and investors.

Economic growth factors are equally important, especially in specific sectors like medical or tech. Rapid job growth and high employment rates can influence the potential success of an investment, as it can create demand from consumers and employees seeking space for their businesses.

In general, different types of commercial properties tend to have different cap rates based on planned use: retail, office, and industrial properties are some of the most common across real estate sectors. Downtown high-rise office buildings tend to have lower cap rates compared to retail and industrial properties operating in suburban areas. For example, during COVID-19, cap rates for retail properties increased indicating higher risk because of a reduction in activity in those locations.

The location of a property often determines the cap rate. High cap rates are frequently associated with riskier investments such as buildings in bad condition or highly competitive markets. In contrast, low cap rates often occur in secure investments with long-term leases such as government-occupied buildings or highly sought-after areas.

When calculating cap rates, investors need to consider multiple factors including property type and location, lease terms, tenant quality, and other economic indicators that could influence long-term value. A favorable economic outlook and strong demographic trends are often associated with more exceptional cap rates.

To illustrate, consider a commercial property located in both downtown and suburban areas of a city. Investors need to analyze factors such as population trends, employment rates, traffic flow, and other economic indicators specific to those regions to generate data to calculate the cap rate. Further research on historical cap rates in those regions could provide valuable context for decision-making.

The key to maximizing returns based on preferred location is to research thoroughly before investing. An investor should look at past cap rates for comparable investments and take the time to learn about trends specific to the region, including future economic changes and intended developments. Investors should also identify reputable real estate professionals in that location and engage with them to ensure that they can execute their investment strategies effectively.

In conclusion, the location of a commercial property is a critical consideration when calculating cap rates. Investors must consider trends in demographics, traffic patterns, accessibility, and economic growth factors specific to a region. Quality data coupled with historical context is invaluable when making investment decisions. Ultimately, a great location, coupled with sound financials, will increase the potential for a high cap rate and benefit investors in their real estate endeavors.

The type of property and its condition can also have a significant impact on the cap rate. Generally, residential properties like apartments, townhouses, and co-ops have lower cap rates than commercial properties like office buildings, retail spaces, and hotels. Properties that require renovation or repair also tend to have higher cap rates than turnkey-ready properties. The major influencing factor in cap rate disparity amongst property types is the predictability of the Net Operating Income (NOI). The NOI is a function of gross revenue minus expenses.

For example, let’s take industrial in this situation. Industrial has been undersupplied for the last several years and there has been a strong demand. Now demand and the lack of supply have caused rents to increase in excess of 10% year-over-year (YoY). At a rate that is attractive to investors that buy properties with rents below market, because when those leases expire there is a higher increase in their cash flow from turning over those leases on renewals or new tenants to market. The revenue increase is the first part, the second is the cost to turn the space for a renewal or a new tenant. For industrial, that is relatively inexpensive and has a low impact on capital expenditure (Capex) by the landlord. So because there is a traditional lack of supply with increased demand that means there is strong and predictable NOI growth and justifies investors acquiring industrial real estate at the same levels as their cost of capital. This is why in the last 3 to 5 years with low-interest rates we saw a lot of industrial properties trading in the under 5% cap rate range.

Let’s go to another asset class that had a majority of the capital spent chasing the property type which is multifamily. In the same instance as industrial, there was high YoY rent growth, low vacancy, and predictable expenses. Now what we are experiencing in 2023 is that in the broader market, we are seeing low rent growth or in some markets rents softening and vacancies rising. Coupled with an increase in borrowing costs, we are seeing cap rates expanding for this asset class at an alarming rate as we are seeing transaction volumes go to near zero because investors can’t forecast the rent growth.

The supply and demand dynamics of a particular property's submarket can also impact cap rates. For instance, if a particular area is experiencing significant demand for apartments, the demand-supply ratio can shift in favor of owners, leading to lower cap rates. Conversely, if an area suddenly experiences a significant uptick in supply, the demand-supply ratio can move in favor of renters, leading to higher cap rates.

In addition to market trends, other factors affect the supply and demand of real estate as well, such as the specific property type, location, local economic conditions, and the current stage of the economic cycle. For instance, if the location of the property is in an area with a thriving economy, the demand for space will be high due to increased employment opportunities. In contrast, if the local economy is facing challenges, such as high unemployment rates or an oversupply of properties, demand will be lower, and the resulting cap rate will be higher than average.

An example of how supply and demand can affect cap rates in real estate is in the multifamily sector. Suppose there’s a surge in demand for studio apartments in a particular area. Investors begin to take notice, and they seek out more studio apartment buildings to purchase. Since demand is increasing, investors can raise rental rates and generate more income. This, in turn, reduces the cap rate and increases the value of the property as it can now produce higher earnings.

However, as the number of studio apartment buildings increases, there will be less demand for individual properties, meaning there is a risk of oversupply. Suppose this causes rental rates to drop. In that case, the cap rate will increase, and the value of the individual property goes down as it is generating lower rental income.

In a seller’s market where demand outstrips supply, cap rates tend to be lower. This is because the high demand and limited supply create competition between buyers, thereby driving up property values. Since cap rates are inversely proportional to property values, higher property values will lead to lower cap rates. For example, in a city with a booming economy where demand for commercial real estate is heightened, the competition for the limited available spaces is likely to drive down cap rates.

Conversely, in a buyer’s market where supply exceeds demand, cap rates tend to be higher. This is because the excess supply means that sellers will have to reduce prices to entice buyers. These reduced prices are likely to result in a drop in property values, which subsequently leads to a rise in cap rates as the ratio of NOI to market value increases. For example, if there is an oversupply of office spaces in a particular MSW, the drop in demand will lead to an increase in vacancy rates and, consequently, a rise in cap rates.

Lastly, the general state of the economy, both on a national and global scale, can significantly impact cap rates. Economic growth, inflation, and non-economic events like war, geopolitical crises, and pandemics can drastically affect demand, supply, and cap rates.

When analyzing investments, investors must keep in mind all of the factors mentioned above. However, it's also essential to analyze each factor's nuances to fully understand how they impact cap rates. For example, a slight increase in interest rates could impact properties differently in terms of their location, property type, market trends, and economic state.

A case in point: The pandemic saw lower occupancy levels in New York City's residential market, leading to higher cap rates during the early stages of the pandemic. However, as residents sought more suburban and rural areas, the trend reversed in 2021, leading to lower cap rates in suburban areas with higher single-family occupancy rates.

The economy has a significant impact on cap rates. Inflation, for example, can increase operating expenses and reduce NOI, which leads to lower cap rates. Conversely, low inflation can result in higher NOI and higher cap rates. Interest rates also play a role, because a rise in interest rates makes financing more expensive and decreases the purchasing power of buyers, which can lead to lower demand for properties and lower cap rates.

Economic growth also has an impact on cap rates. When the economy is strong, rents increase and vacancy rates decrease, which can result in higher NOI and cap rates. In a weak economy, rents could decrease, vacancies increase and operating expenses grow, all decreasing NOI and lowering the cap rate. Additionally, some property types such as office buildings, hotels, or commercial properties have specific economic factors that can impact the cap rate more than other property types. For example, the office market cap rate may fluctuate based on the strength of the economy and job market.

It is important to note that these factors work in conjunction with market trends and other indicators of supply and demand for property, by incorporating local economic trends like local employment or migration data.

For example, during the 2008-2009 financial crisis, cap rates trends reflected a weak economy, the bubble in the housing market burst and put downward pressure on the underlying home values. The resulting foreclosures caused an increase in multifamily demand, leading to a drop in cap rates across those markets.

In summary, to assess an investment property's long-term prospects accurately, real estate investors must look beyond value projections and cap rates' numerical values. Instead, they must make a broader assessment of the market trends, location, property type, supply and demand, and the economy in general. By looking beyond the sticker price, investors can make more thorough investments that will sustain returns over the investment's lifetime. From all the influencing factors described above the heaviest weighted influence of a cap rate is the predictability of the NOI.

The relationship between NOI predictability and cap rate hinges on how changes in supply and demand affect the price and net operating income of a property. In a seller’s market where demand outstrips supply, competition between buyers drives up prices. As prices rise, net operating income decreases because expenses such as insurance costs remain fixed while total revenues increase at a slower pace than prices due to higher vacancy rates. This leads to lower cap rates since fewer dollars are available for returns. On the other hand, in a buyer’s market where there is an oversupply of properties compared to demand, prices tend to be lower – leading to higher net operating incomes and subsequently higher cap rates because there is more money available for returns.

Example 1: Suppose there is an apartment complex on sale in an area where properties have been experiencing high demand but limited supply due to land scarcity. In this situation, competition among buyers would be high – resulting in higher prices for properties–and consequently lower net operating incomes due to increasing vacancy rates and smaller margins per sale or rental agreement. These conditions would lead to relatively low cap rates since fewer dollars are available for returns after all expenses have been paid out.

Example 2: Conversely, consider an area with stagnant population growth which creates high vacancy rates for real estate holdings due to a lack of interest from buyers or renters, resulting in falling prices As prices decrease so too does net operating income – the reason being that total revenues fall faster than expenses which remain fixed — leading to higher cap rates since more money remains available for returns after all expenses have been paid out.

Investors need to understand these dynamics surrounding NOI predictability and cap rate if they are going to make informed decisions when considering real estate investments. They need to assess whether their target properties exist in a seller’s or buyer’s market, analyze local economic conditions including population growth, vacancy rates, etc., determine whether certain factors could potentially push up or reduce overall sales/rental margins, and calculate estimated future NOIs accordingly based on these factors; only then can they accurately gauge potential returns on their investments.