In real estate, understanding cap rates can lead to better investments and returns

Based on the research of Sheridan Titman

For commercial real estate investors, economic crosswinds make today’s markets treacherous. Interest rates are high while office occupancy rates are low, as the work-from-home trend persists. Workers are moving from bigger cities to smaller ones.

Each of these trends affects a basic question of real estate investment: How much should a buyer pay for a property? A key metric that real estate professionals use to understand property valuation is the capitalization rate, says Sheridan Titman, a professor of finance and the Walter W. McAllister Centennial Chair in Financial Services at Texas McCombs.

The cap rate, he explains, is the ratio of a property’s net operating income to its overall value. A $10 million office building that generates $550,000 a year in income has a 5.5% cap rate. Knowing a market’s average cap rate helps investors assess the profitability of a potential investment and compare it with other properties in the same market.

Cap rates vary significantly over time and geography. In a series of recent papers, Titman analyzes how and why. Understanding these factors, he says, can help investors make better decisions. This interview has been edited for length and clarity.

Cap rates aren’t a familiar term. Why use them to talk about commercial real estate values?

When real estate people talk about how much they’re paying for a property, this is how they communicate. They ask, “What are the rents like, and what are the cap rates?”

When the cap rate is lower, they’re willing to pay more for a building to get the same level of rental income. In other words, the value of the building is higher than a comparable one with a higher cap rate. There’s an inverse relationship between valuations and cap rates.

If two properties generate the same income but have different cap rates, an investor will compare them and try to understand why. The property with the higher cap rate may be in a declining market, or it may be riskier. Or maybe the seller needs to quickly unload it and will accept less.

What causes cap rates to rise or fall?

Cap rates are determined by three factors. The first factor is the risk-free rate of interest. That’s the return you receive on investments with zero risk. When risk-free rates increase, cap rates tend to increase.

But most investments are somewhat risky, and the second factor is the actual level of risk. When real estate becomes riskier, cap rates tend to increase.

The third factor is the expected growth rate. When rents are expected to grow, cap rates tend to be lower, because investors expect higher future income.

How have these factors been playing out?

My research documents a lowering of cap rates worldwide from about 2000 to 2020. This corresponds with worldwide decreases in risk-free rates of interest.

More recently, cap rates have increased, reflecting recent increases in interest rates and risks.

How do cap rates vary across locations?

We see substantial variations from city to city. For example, cap rates tend to be lower in financial centers and gateway cities like New York City and Shanghai, where rents have historically increased more.

We also see variations in cap rates across locations within cities. In almost every city, suburban office buildings have higher cap rates than office buildings in the downtown area.

What accounts for such differences?

Density is a big factor. In general, denser locations tend to have higher property values and lower cap rates. That’s why rates are lower in central business districts than in suburbs.

Why is density important?

In less dense locations, like suburbs, if the demand for property increases, developers will build more buildings, which will mute the upward pressure that demand puts on rents. But in the central business district, the availability of land for new buildings is more constrained, so prices will increase more when the demand for space increases.

But density isn’t the only variable. Some suburban business districts have particularly good transportation, which makes them particularly attractive. In those districts, buildings with access to good transportation have lower cap rates.

Meaning investors are willing to pay more for them?

Yes. In Austin, for example, if a light-rail system gets built, it should increase the value of buildings in outlying areas with good access to rail lines.

You found that cap rates tend to be higher in smaller cities. Might that change with the post-COVID exodus from larger cities to smaller ones?

When individuals migrate to relatively small cities, they can trigger a virtuous cycle: a feedback loop where the city becomes more attractive to a set of skilled individuals, and their increased presence makes the city more attractive to companies that value those skills. As these companies increase their presence, the city becomes even more attractive to individuals with these skills. It also draws restaurants and other services, which further add to the city’s vibrancy. This cycle can continue until property values become unaffordably high.

This happened in Austin in 2021 and 2022. Investors anticipated a continued influx of new residents. They bid up the values of apartment buildings, and we witnessed what were previously viewed as unheard-of low cap rates.

Today, cap rates in Austin have come up from those lows. Does this make it a good time for investors to buy?

As an academic, I’m good at predicting, just not about the future. For a city like Austin, we need to think about where we stand in the virtuous cycle. If we expect companies and skilled workers to continue migrating to Austin, then the relatively low cap rates can be sustained. If we think the cycle is played out, then cap rates might see a correction.

“City Characteristics, Land Prices and Volatility” is published in Journal of Urban Economics.

“The Determinants of Office Cap Rates: The International Evidence” is published in Real Estate Economics.

“Location Density, Systematic Risk, and Cap Rates: Evidence from REITs” is published in Real Estate Economics.

Story by Steve Brooks