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Cap rates have hit new lows by most measures. This means buyers are willing to accept less current income relative to the purchase price. Should we be worried? That depends.

Before we analyze whether there’s cause for concern, let’s first define a cap rate and the current drivers of the newly low rates. A cap rate is net operating income (NOI) divided by adjusted purchase price. For example, a property with $100,000 in NOI that sells for $1 million equates to a cap rate of 10 percent. There are several factors driving current cap rate compression. First, investors believe income will increase due to higher rents. Space availability continues to decline, aided by limited new construction; this, combined with positive absorption, means rent increases. Second, quality properties for sale are scarce. When they do come to market, brokers are reporting multiple initial offers and several “best and final” rounds. Availability of equity and debt is plentiful while quality properties for sale are not.

There are three main points that can help us decide the state of the cap rate and what it means for the real estate market in the future: the spread between a cap rate and risk-free rates, the fact that cap rates are “sticky,” and the average real estate income.

Spreads and rates

The spread between cap rates and risk-free rates is important for determining how much risk premium investors attribute to real estate. According to data from CBRE Econometric Advisors, the spread to the risk-free rate was 455 basis points (bps) in 2003 and 58 bps in 2007. The current spread of 357 is significantly higher than the 2007 market peak. This means investors are getting a higher yield from real estate assets relative to 10-year treasuries, a sign of a healthy real estate market.

In a rising interest rate scenario, the economy should be improving. An improving economy is also good news for real estate fundamentals. Given the market expectation that risk-free and corporate bond rates will increase in the mid- to long-term, cap rates are less likely to decline further. Assuming real estate income increases over the same period of time, value increases should be modest. The math is fairly simple: if the cap rate is static and income increases 3 percent, the calculated value increases 3 percent. The “sticky cap rate” in this scenario results from the correlation between rising interest rates and an improving economy.

Lagging incomes

Income is half of the cap rate, and the news is generally good here as well. Overall, income is expected to increase; CBRE Econometric Advisors reports the following on rents (income) for the four major property groups:

In the office sector, real rents are at or near record lows. Last year was the best year since 2006 for industrial rent growth. In the retail sector, average national rents have not grown since 2007. Positive growth is finally projected for 2014. Multifamily assets have seen rent growth of more than 4 percent over the last two years, and projected rent growth is in the 2 percent plus range over the next few years. The income lag occurs because it takes time for landlords to raise rents with multi-year lease terms.

If investors continue to push cap rates below current levels, this could be cause for concern, but all factors need to be taken into account. Smart real estate investors will keep an eye on the spread between cap rates and risk-free rates, which currently remains healthy. “Sticky” cap rates can provide stability in a rising interest rate environment. Finally, income growth typically lags behind improving (and declining) market forces.

This article was republished with permission from National Real Estate Investor.