So Cap Rate is defined as Current NOI/Property Value. And Cap rates are used to guage risk/return of a CRE investment. Pretty straightforward.
Ex. a CRE office has $4mn annualized NOI in 1Q 2023, and a latest appraisal value of $100mn. so cap rate is 4%.
So let’s say you’re assessing this property today (April 2023) and vacancies have shot up in the past week (some pandemic), and are expected to remain high indefinitely.
As someone gauging the risk, obviously the risk is higher. But how is the cap rate magically higher? Is it simply that “expected” 2023 NOI goes up as landlord adjusts rents higher to compensate for the vacancies (or “expected” Property Value goes down as investment interest declines)?
I think I’m just getting confused of whether this is some literal calculation based on current period actual data to date, or whether it’s simply plugging in forward estimates of NOI and Property Value, which presumably everyone has a different opinion/view/prediction on.
You should consider NOI expected in above formula. If Cap rate is of 2022, this holds.
When vacancies are shot up, it will increase your opportunity cost and hence expectation of higher interest rate which increases discount rate and thereby cap rate.
I’m not on this subject yet, but having past experience in the commercial real estate sector, I think that cap rates are like “benchmark” performance measures implicitly obtained from the market. As you gather observable data on rent levels (so you can calculate NOI for a specific property) and you know prices of properties (from market value data, past transactions, appraisal indexes, etc), you can calculate the implicit cap rate of properties. There is a desired cap rate level in order for a property to be attractive. That level is around 8-10%.
As long as real estate is not the only asset class available in the market, investors require a certain level of cap rates on future property acquisitions, say 8%. If NOI is expected to fall due to a hike in the vacancy rates, therefore the market value of that property must be adjusted to keep its cap rate unvariant the most.
On your example case, If I saw a property with a cap rate of 4% I would consider it overvalued.