What is a CAP Rate?
Commercial real estate investors face numerous challenges in evaluating properties and determining whether they are lucrative investment opportunities. One major factor to consider is the capitalization rate, which is a ratio that measures the expected return on a property based on the expected income it will generate. In simpler terms, capitalization rate is the percentage rate at which you are earning a return on your investment.
Interest rates are a crucial element and are deeply connected to the capitalization rates of commercial real estate. When interest rates are low, the cost of borrowing money for real estate investments is less, which can make it highly attractive for investors. If demand is higher than supply, capitalization rates will likely drop because the premium paid will have to decrease. On the other hand, higher interest rates can have a significant impact on the capitalization rate. When the cost of borrowing money for investment is high, investors have the incentive to demand higher returns on their investment to offset the cost of borrowing. When demand for real estate investment decreases in such cases, capitalization rates increase because investors will be less likely to pay a premium for a riskier, less profitable investment.
Furthermore, there is a direct relationship between interest rates and cap rates in commercial real estate. In situations where capitalization rates are rising, demand for commercial real estate investment properties decreases, and interest rates are highly likely to rise to correct the supply-demand imbalance. Conversely, if there are low interest rates, buyers will be more financially positioned to pay more for a property designated to produce a high yield. In conclusion, interest rates undoubtedly have a direct impact on the capitalization rate of commercial real estate investments. Whether you are a seasoned property investor or newbie in the game, monitoring interest rate changes will help you develop and execute better investment strategies.
Other major factors impacting CAP rate are the type of property, the quality of construction, age, location, and overall desirability. Industry jargon also classifies properties into Classes: Class A, Class B, Class C, and so on. Projects such as warehouses we have built tend to be lower in class, and therefore higher in capitalization rate. Trophy buildings such as the ones we have done in Ferguson Farm or our upcoming Hotel, tend to have very low capitalization rates. Lower rates mean higher values, and vice versa. Conversely, higher capitalization rates mean higher cash flow, and vice versa.
