Capitalization Rates: Identifying Markets for Higher Capital Gains

capitalization rates

Smart property investors should be looking for properties that are likely to increase in value because that is how they will stand to achieve capital gains when they sell their property investment. As explained in my post regarding the thinking framework for smart real estate investments, property values go up when capitalization rates go down in periods in which rents remain stable or are rising. Capitalization rates represent a required or acceptable income return by investors. As such, they are determined by three major factors (see Figure 1 below):

(1) Perceived risk associated with the investment under consideration

(2) Investor expectations for future property value increases (appreciation)

(3) Required returns in alternative investment vehicles, such as stocks and bonds

Risk is the uncertainty associated with the future income stream and/or capital gains expected from the investment.[1] For example, a government bond has zero risk, because there is no uncertainty regarding the income return on such an investment; the US Government guarantees interest payments on these bonds. On the contrary, corporate bonds are not considered as riskless since there is no guarantee that the company issuing the bond will be able to make the interest payments.

Figure 1 – Market Factors that Trigger Increases in Capitalization Rates

Capitalization rates

In real estate, risk can be defined as the uncertainty with respect to the property’s income-earning capacity, which is typically measured with the Net Operating Income (NOI) that it produces, and value. Investors’ risk perceptions regarding a property’s prospects should be influenced by the economic and real estate market conditions prevailing at the time of the purchase. All else being equal, one would expect that when the real estate market is strong, with rising rents, high levels of absorption, and declining vacancy rates, investors will feel less uncertain about the property’s future cash flows and appreciation prospects. This lower uncertainty will translate to a lower risk rating, allowing investors to accept lower returns and lower capitalization rates (see Figure 1). This proposition is supported by the findings of a study by Sivitanidou and Sivitanides (1999), who verified empirically that when market conditions are strong, office capitalization rates are low.

Location and Property-Specific Influences on Capitalization Rates

The performance of a property is affected not only by the broader market conditions but also by location and property-specific factors. These location and property-specific factors also affect risk perceptions and the capitalization rate an investor may use to calculate the maximum price he/she is willing to pay for a property. For example, an investor may consider a 30-year-old property as riskier than a new one. I can think of many reasons why that would be true, such as the greater risk of functional obsolescence or greater overruns of maintenance expenses (beyond those normally accounted for buildings of this age).

Other location-specific factors that may affect an investor’s risk perceptions have to do with the stage of development of an area. An investor may consider the purchase of a property in an area with little development, infrastructure, and supporting services as more risky, compared to a property located in a fully developed neighborhood. The former may have greater value appreciation potential, but if the neighborhood is in the early stage of development, there is also greater uncertainty as to whether development will intensify, and when. That is why new massive development in a mostly undeveloped area will decrease the risk of existing properties and contribute to decreases in the cap rate investors use to estimate the price they are willing to pay for such properties.

Sivitanidou and Sivitanides (1999) have confirmed the influence of another factor, which can be linked to the perceived risk of real estate investments. This factor has to do with the diversity of the local economy and office market. The term “diverse office markets” refers to markets in which office employment composition is uniformly spread throughout several economic sectors, as opposed to only a few sectors. The argument is that non-diverse office markets are more risky; if the sector in which most of the market’s office employees are active takes a hit, there will be a significant negative effect on local office space demand, leading to declines in property income and values. Sivitanidou and Sivitanides found a strong statistical relationship between high diversity in an area’s office tenant base and low capitalization rates. They also verified that markets with stable office-employment growth rates tend to have lower capitalization rates. Within the theoretical framework developed so far, this effect can only be linked to investor risk perceptions.

Another factor that may affect the investor’s required rate of return, and therefore, the capitalization rate, is expected appreciation. Investors make their decisions based on the total expected return, which is the sum of income return and appreciation or capital return. To understand how expected appreciation may affect the market capitalization rate, consider an investor who requires a total return of 12% on his/her investment. In evaluating a property for acquisition, the investor is told by a real estate adviser that the expected appreciation rate for the property is estimated at about 3% annually. Given the total return requirement of 12%, the investor will buy the property only if it is priced so that it offers a 9% (twelve percent minus three percent) income return, at least. If the investor’s consultant estimates expected appreciation at 5%, the investor would be willing to accept a lower income return and buy the property at a price that corresponds to a capitalization rate of 7%.

The bottom line is that when market-wide expectations of value increases are high, market capitalization rates should be low; when the expectations for value appreciation are low, capitalization rates should be high. Notice that investor expectations regarding the future appreciation of a property are influenced by the same factors that influence risk perceptions, that is, indicators of market strength (see Figure 1).

Since real estate competes in the capital market for investment funds with alternative investment vehicles, such as stocks, corporate bonds, and government bonds, the level of returns offered by these vehicles should influence the return required by real estate investors. If returns in stocks and bonds decrease, relative to real estate, more capital will flow to real estate, pushing down required returns from property investments and capitalization rates. This is what has been happening in the last three or four years, after the stock market crash of the 2000 and the dive of interest rates (which influenced the return of bond instruments) to historic lows.[2] One of the major concerns of real estate investors in today’s environment is the prospect of rising interest rates; such a scenario will most likely push capitalization rates up and hurt property values.

What Markets and Properties are More Likely to Register Falling Capitalization Rates

In sum, the factors and circumstances that trigger capitalization-rate declines and, therefore, property-value increases (assuming that everything else remains constant) include:

(1) Decreases in risk/uncertainty regarding the future performance of a property due to:

– Improving market conditions, as measured by increasing rents, falling vacancy rates, high absorption levels, and accelerating employment growth

– Significant developments in the vicinity of a property, which improve its accessibility, supporting services, etc.

(2) Expectations for higher appreciation rates, which are influenced by the same factors as risk perceptions

(3) Decreases in interest rates and stock/bond returns

Some of the factors mentioned above pertain to local market conditions and some pertain macroeconomic forces that influence all markets at the same time. Based on the framework developed so far, it seems that investments in markets expected to experience significant improvements in their supply-demand fundamentals, during periods of poor stock returns and low interest rates, can take advantage of the most favorable circumstances for property value increases, since they will boost property income and compress capitalization rates at the same time.

[1] Investment analysts tend to measure risk as the volatility of past historical performance. So stocks are considered as quite risky because their historical performance has been very volatile. Based on the same measure, bonds are considered less risky. The volatility of the performance of real estate investments, as reflected in the NCREIF data is not directly comparable to the indices measuring stock and bond performance, because property values/prices are based on appraisals and not transactions, as is the case for stock and bond indices.

[2] The 2000 stock market crash was triggered by the burst of the tech bubble and was reinforced by the September 11, 2001 terrorist attack. It started in January of 2000 and ended in October of 2002, after stocks registered a loss of 38%.

References

Sivitanides, P.  2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.

Sivitanides, P. and R. Sivitanidou. 1996. Office Capitalization Rates: Why Do they Vary across Metropolitan Office Markets? Real Estate Issues, Vol. 21, No. 2, pp: 34-39.

Sivitanidou, R. and P. Sivitanides. 1999. Office Capitalization Rates: Real Estate and Capital Market Influences. Journal of Real Estate Finance and Economics, Vol. 18, No. 3, pp: 297-322.

Sivitanides, P., J. Southard, R. Torto and W. Wheaton. 2003. Real Estate Market Fundamentals and Asset Pricing. Journal of Portfolio Management, Special Issue, 45-53.

Relevant Posts

Properties with Significant Market-Driven Potential for Capital Gains
What types of property have big profit potential?
Achieving High Returns by Riding the Real Estate Cycle
Property Investment Basics: Cap Rate Formula

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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