The Key to Successful Real Estate Investments
Cap rate expansion is expected to continue in the short term for most real estate asset types and may peak later this year. Experts predict a noticeable decrease by 2024, as the end of the Federal Reserve’s rate-hiking cycle is highly anticipated. But for now, what does this mean for property owners and investors?
Risks of High Cap Rates
Rising cap rates can be a red flag for property owners and sellers, indicating a less appealing investment prospect. High cap rates may suggest that the market is less confident in the property’s ability to generate income, implying high vacancy rates, unfavorable lease terms, or other difficulties. Furthermore, high cap rates may indicate adverse market conditions, such as high-interest rates, which may harm property values and returns.
As the cost of capital and the risk of investments grow, lenders and investors become more careful and selective.
Benefits of Increasing Cap Rates
Though the CRE industry is navigating a volatile market, there may still be some good to these expanding rates. High cap rates hold potential for buyers because they typically mean a lower purchase price relative to the NOI. This can translate into a higher rate of return on investment, making the property more attractive to potential buyers. Additionally, high cap rates can indicate market distress or unfavorable conditions for property owners, which could lead to more favorable negotiation terms for buyers.
What to Expect in 2023
At the end of Q1 2022, it was evident that the expenses related to interest rates were negatively impacting CRE transactions, and by Q4 2022, the prices had only increased. 2023 has been no different; increased borrowing costs and monetary policy uncertainties are pushing cap rates even higher.
Interest rate cap costs are putting a strain on real estate transactions, causing some to walk away from deals. The Secured Overnight Financing Rate (SOFR), a common benchmark for interest rate caps, is rising and now stands at 5.08 percent as of May 30th, 2023, according to The Federal Reserve Bank of New York. At the same time, GlobeSt. recently stated that the short-term treasury bond yields had reached their highest levels since the early to mid-2000s. As a result, interest rate caps are becoming more expensive, with a three-year cap at three percent for $50 million costing more than $1.68 million, according to Chatham Financial’s calculator.
How to Combat Rising Rates
There are several ways investors can combat rising cap rates:
- Increase Property Income: This can be done by increasing rent, reducing vacancies, or adding amenities that can generate additional income.
- Reduce Expenses: Investors can negotiate better contracts with vendors, reducing energy usage or cutting back on unnecessary costs.
- Improve Property Condition: Improving the property’s condition can increase its value and reduce the cap rate. This can be done by renovating the property, upgrading its systems, or enhancing its curb appeal.
- Repositioning the Property: Repositioning the property can involve changing its use or focusing on a different tenant base. However, repositioning can involve significant capital expenditures and may require a long-term strategy.
Takeaways
High cap rates can be both good and bad news in CRE, depending on the context. Buyers may benefit from a higher rate of return on investment but have a higher level of risk, while property owners and sellers may face challenges in attracting buyers and maintaining property values. As with any investment decision, it’s important to consider multiple factors and consult with industry experts when deciding how to deal with these rising rates.
