When market interest rates rise rapidly, a unique phenomenon known as Cap Rate Compression becomes evident in commercial appraisals. When conservative investments, such as treasuries, are yielding upwards of 4% with minimal risk, the cap rate for commercial property investment must also become higher.
What is a Capitalization Rate (“cap rate”) in commercial real estate?
The cap rate is the return rate figure that CRE investors use to gauge the risk and potential return of an asset or property. Cap rates are expressed as percentages, and they are inversely related to a property’s price. The lower the cap rate, the higher the price (opposite is also true). The theory is that in order to incentivize an investor to incur the risk that comes with a commercial property investment, the overall return must be worth the risk. Therefore, cap rates rise in an inflationary time, while cost of money and rates are rising.
For example, a building that was appraised at the end of 2021 and came in with a reported cap rate of 5.5%, may now have an implied cap rate of 6.5% or more – making the value conclusion or final price that the appraiser arrives at significantly lower than it was for the identical building less than a year ago.
How do Cap Rates affect my investment strategy?
It means that we’re shifting from a seller’s market to a buyer’s market, and prices are coming down whether the seller knows to adjust them based on current market conditions or not. If the sale price is not adjusted, the amount that any lender is willing to provide in financing will be based on the lower appraisal. The net effect is that prices will come down, one way or another. This is the Fed’s overall intention in adjusting the federal funds rate and controlling inflation. Ultimately, they are putting the brakes on the runaway prices and a resulting overinflated market .
This is a first signal of the shift – and a great sign that it’s time to consider investment property purchases or expanding your business again. Here are two moves that investors should especially consider during this time:
1. Stop Renting and BUY Your (Business’s) home.
Is now really the time? YES! As explained above, cap rate compression is causing prices to go down – making it more affordable to buy than to rent. For example, in Florida, rents are up 40% – and rising. So stop waiting around!
You remember that overpriced building you looked at months ago? Check it again! Let us get you prequalified so you’ll be prepared to make an offer when the right move lines up.
2. Forget Fixed Rates- Go HYBRID.
Buying an income property with a 30-year fixed rate at 7% … you might run into some cash flow complications. So what do you do? Choose a loan with a hybrid rate. A hybrid rate is an index, similar to prime, plus a margin.
Picture that money in your pocket today… plus a discount rate to start! Then, the rate will then reset at a future date, during a time in which rates will likely be much lower than they are now! Get prequalified, know your options, and be ready!
Remember, submitting your deal for review or using our Loan Finder App is always risk-free with no commitment necessary — because we are invested in your success! We want to help you strategize for your future, and take a personal role in making that success happen. Don’t just take our word for it – check out our 5-star reviews on Google.