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.
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.
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.
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