What is Cap Rate Compression?

Real estate investors seeking potential places to park their investment capital often examine cap rates to determine the viability of investment opportunities. 

The capitalization rate of an investment property is an important financial metric because it gives investors a baseline idea of how long it would take them to fully recover 100 percent of their investment capital in all-cash deals. Let’s take a closer look at how cap rates are determined, cap rate compression, and some of the factors that can drive down capitalization rates.  

How to Determine an Investment Property’s Cap Rate 

You can find the cap rate of an investment property by taking the asset’s annual net operating income (NOI) and dividing it by its fair market value. 

Cap rate=NOI/market value 

Here are three examples: 

Investors shouldn’t base investment decisions solely on cap rate projections, since a host of other factors, including location, desirability, investor demand, and tenant occupancy, all affect the viability and income-generating potential of an investment property. 

What Drives Down Cap Rates 

Cap rates move up or down – the downward trajectory is called compression – with changing economic and market conditions. 

Cap rates tend to compress when there is strong investor demand to invest in properties, which makes their values rise. Falling cap rates may not be ideal for prospective investment opportunities, since the property will cost you more, but they could be a boon for current property owners who may realize significant asset appreciation upon divestiture. 

Cap rates also can compress based on supply and demand. In many primary and secondary markets, industrial buildings, distribution warehouses, and multifamily apartment complexes often have compressed cap rates because of strong investor demand for these asset classes. Compressed cap rates for high-demand properties can lead to increased rental payments from tenants, as landlords are often able to push rents above market rates for desirable investment properties. This bump in rental payments can lead to increased cash flows, which benefits current landlords and may lead investors to pay higher prices for coveted assets. 

Cap rates are correlated to interest rates. Falling interest rates (remember those?) lead to cap rate compression because real property investors can borrow more money for less and acquire properties that might be out of reach in a high-interest rate environment. 

Tenant profile also can affect a property’s cap rate. When an ultra-creditworthy tenant signs a long-term lease for a Class A space, that building will likely trade hands at a compressed cap rate due to the financial strength of the tenant, which translates to reduced risk for the investor. Landlords looking to sell also can ask for higher values based on the creditworthiness of their tenants, which can lead to cap rate compression for the asset. 

High-profile tenants making long-term investments in a particular region can affect the cap rates of surrounding properties as well since investors often snap up land and properties in close proximity to the tenant. Examples include the buildings surrounding professional sports stadiums and arenas, or properties near tech hubs in cities such as Austin, Seattle, Boise, or Salt Lake City. 

Putting it all Together 

Cap rate compression is driven by a wide range of factors. Property owners seeking to unload well-positioned assets will likely enjoy compressed cap rates because their assets will trade hands at higher values. Compressed cap rates also can reflect higher rental payments and greater cash flow expectations over the long-term. 

Investors should use a property’s cap rate as a rough guide – taking a closer look at the factors that are driving down and influencing the asset’s cap rate will likely provide a much clearer picture of the property’s viability as an investment.