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  • Ashley Wilson

Should We Throw Cap Rates Out the Window?



Everywhere you turn people are talking about the changes in values. On the news, reporters are talking about home values going down; in commercial real estate, lenders and brokers are talking about the cap rate expansion (which signifies declines in values). With everyone talking about values going down, it must be true, right?!?

Before I address this question, I want to first address the definition of value. One definition of value is the estimate of the monetary worth of something. So how do we “estimate” the monetary worth?

In residential real estate we have historically used the comparable sales approach. This allows a similar house’s sale to be used as a benchmark to determine the price point in which a comparable house should transact. In commercial real estate there are three ways in which to estimate the monetary worth. First, is the comparable sales approach. Second is the replacement value approach (think of how insurance companies perform an appraisal to determine the cost to rebuild a structure in the case of a catastrophic event). And third is the Net Income Approach (or NOI Approach) in which the property’s annualized profits minus expenses are divided by the trading market cap rate. Historically, the NOI Approach has been the preferred method for investors when purchasing commercial real estate, but is that about to change?

As interest rates continue to creep up there is a trickle down effect on the trading cap rates. In other words the market cools down as the debt (the largest part of the capital stack) becomes more expensive and in turn decreases what one can pay for a property. The problem with the NOI evaluation method in this scenario is the lag time between interest rates impacting cap rates. The other problem is typically a rise in interest rates inadvertently impacts other commodities, for example building materials. Thus, replacement values surge. To put this in perspective, if you looked at an apartment in Q1 2022 the asking price could have been 180k/door. Today, with the current interest rates, let’s say you can only pay 150k/door. However, if you were to rebuild that same property, maybe you can only do it for 175k/door. So, what is the value?

Personally, I don’t think the answer is straightforward. I actually believe it to be a combination of both the NOI approach and the replacement value approach. If you are thinking I am making an argument to invest for appreciation, you are half right. Before everyone grabs their torches and pitchforks I do not believe in investing solely for appreciation. However, at some point cap rates will cease to expand. They might become stagnant or they might start to compress again. Unfortunately my crystal ball is broken so I do not 100% know the answer. As history tends to repeat itself, I am guessing they will compress again at some point, which if you believe in my argument above about not being able to build at the same price as what some apartments are asking today, the apex might be near.

There is one other factor to consider and that is investment risk profile. As the stock market remains the standard of which most investments are compared against, it is important to consider alternative investments' influence on each investment option. Multifamily real estate has historically been known as one of the safest investments, personally I believe much safer than the stock market. However, if you look at the stock market’s longterm profile, it historically returns 8% while remaining a very liquid investment option. The majority of multifamily investment vehicles, while returning higher returns, is not so liquid. These factors also influence where investors place their capital, which in turn, impacts pricing.

While I will not pretend to solve this question in one post, I do believe that the historic method of the NOI approach being the sole method in evaluating multifamily property values is no longer valid. What other factors do you think should be considered when determining value?


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