can u elaborate with sample numbers, for the layman, as u did with previously?
Just really briefly the cap rate is a measure of yearly net operating income as a percentage of the market value of the property. If you buy a property valued at $1 million for cash and the property is generating $100,000 of operating income each year that is a cap rate of 10 or 10% of the market value. As prices have gone up in recent years, cap rates have gone way down. Meaning people are paying more for properties that are yielding less.
It was not uncommon to have cap rates at around 3.5 which means that the property is yielding net operating income of around 3.5% of the market value of the property annually. Of course few people will accept a 3.5% return on their money. However, there is often an expectation that rents can be raised especially if improvements are made to the property so what looks like a 3.5 cap is anticipated by the investor to eventually produce a higher yield which will also push up the value of the property.
For example, if a $10 million property was producing net operating income of $350,000 or a 3.5 cap and you can raise the income to $700,000 over a few years, as long as cap rates remain at 3.5 that property would now be worth around $20 million. Additionally, cap rates were actually coming down over much of the last decade as prices shot up, which increased the value of the property, even if income stayed the same. This was largely a function of interest rates continually going lower for reasons I’ll explain.
If you could borrow 80% of the purchase price of a 10 million dollar property at 2 1/2% then you are leveraging the cash you are putting in because the 8 million you are borrowing at 2.5% is yielding 3.5% so that magnifies the return on the 2 million cash portion of your investment to far more than 3.5% (this is a simplification ignoring many other expenses and factors.)
Then they were also the speculators who bought simply because they thought someone else down the road will pay a higher price much like happens with momentum stocks, and this was also a factor in the prices going sky high.
Fast forward a few years and that 3.5 cap property now requires a loan at 7%. This means that all things being equal every dollar of the 8 million that you are borrowing at 7% is only yielding 3.5%. That is actually hurting your return. Your cash portion is yielding 3.5% but your loan portion is losing money and could very well be wiping out any yield from the cash portion. To buy the property at that price you had better you have a very good game plan or unusual opportunity, such as rents that are way below market or some other factor that will make it worthwhile despite the lousy numbers . In general, the higher interest rates are going to naturally put pressure on the cap rates for the reasons above.
To put things another way the bank is getting 7% on its money with relatively little risk. They have first dibs on the property in the event of a default. Granted, they may not recover the entire value of the loan , but because they’re only lending out a percentage of the full value, even if valuations go down, they stand to recoup most of their money, even if the investment is a flop. The investor on the other hand is taking the risk of losing all his capital and only getting a yield of 3.5% on his money, even less when considering the negative leverage. In theory, the greater the risk that is taken the larger the return ought to be , so something is off; the market is not where it should be and prices need to come down significantly (cap rates need to rise.) there will always be exceptions and niche opportunities but in general the numbers out there today do not support current market valuations, and something is going to give.
