Cap Rates - Interest Rates and Vacancy Rates

CFA Level III
#1

Cap Rate = NOI/Property Value

Just looking at this cap rate equation alone, I am having trouble understanding the following points:

  1. The cap rate itself is negatively related to the availability of debt financing.

  2. The cap rate is positively related to changes in interest rates and vacancy rates.

Looking at the equation, I’m focused on next year’s NOI in the numerator → higher vacancy rates should mean lower NOI next year which would reduce my cap rate?

Or is the denominator in this equation dominating the cap rate → higher vacancy rates decreases the property value, higher interest rates decreases the property value because less borrowing of higher rates leads to less demand, and vice versa for increased availability of financing, increasing demand and thus property value, reducing the cap rate? Is the numerator here just considering next year NOI is static forever like gordon growth with next year’s dividend and the economic conditions are only affecting the property value in the denominator?

#2

I don’t think so. Higher vacancy rates may require a higher NOI for compensation. Thus, there should be a high cap rate for riskier property types, low-quality properties and less attractive locations.

In the long run, the expected real estate return equals cap rate plus NOI growth rate. The NOI growth rate usually equals the growth of GDP. Cap rate equals NOI / property value as part of required return of real estate. We use this formula estimating whether the deal meets our expectations. Thus, the property value is given now and you estimate the NOI base on conditions like vacancy rates.

Those rates above are not one-way effects. For example, the cap rate is procyclical, it rises when the economy is good. But this process could also be mitigated by the sensitivity to credit spreads and availability of credit.

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