Cap Rates 101 Part 2: How Do Higher Interest Rates Impact Cap Rates & CRE Investment Decisions?

In an ultra-competitive business banking landscape, the easiest way to win over business owners is by offering up valuable insight that they can use to help them address the challenges and opportunities they are facing in the marketplace!  Business owners invest in commercial real estate (CRE).  They either purchase owner-occupied CRE or investor CRE.  Cap rates impact the valuation of CRE and how much debt an income property (Investor CRE) can support.  I posted a LinkedIn article titled “Cap Rates 101:  How Do Cap Rates Impact The Loan On An Investor CRE Property? ” that explains the concept of the cap rate (see article: https://www.linkedin.com/pulse/cap-rates-101-quickly-determine-loan-investor-cre-support-castillo-1c/?trackingId=yR3PzVEVQJC0cmezOM6r6g%3D%3D).

This article is a follow up (Part 2) to that article.  This article will briefly cover the impact rising interest rates have on cap rates and CRE investment decisions. 

Inflation surpassed 9% in June of 2022 and the Fed responded with a series of rate increases that drove interest rates sky high!  Higher interest rates significantly increased the cost of borrowing for consumers and businesses.  The impact is already being played out in the market.  Consumer sentiment is down, home prices are starting to fall and home sales are declining as well! However, these market forces don’t always impact the rental market in the same way or at the same time.  Renters, who are looking to purchase homes, measure affordability through the lens of the monthly cost of owning a home.  If the monthly cost of owning a home—due to higher interest rates—is higher than the cost of renting, there are renters that will stick with renting!  This, in turn, drives up demand for rental housing and keeps rents high even as home prices drop!  During a recession, unemployment goes up, people lose their jobs & homes, and home prices start to fall. As a result, there is an exodus to rental housing which drives up demand.  However, there can be higher rent defaults and eviction rates during a recession which adversely impacts the net operating income (NOI) and cap rate on rental properties.  Higher rent defaults and vacancies can lower NOI and increase cap rates. 

In an inflationary environment marked by increasing interest rates, it is possible for the rental rates to increase the NOI of a rental property.  However, a prolonged inflationary environment can also have an adverse impact on the market which could drive up cap rates.  Below are two scenarios that show how this could play out.  The assumption we are making is that we are looking at a rental property with a base NOI of $125K and an estimated market value $2.5M which results in a base cap rate of 5% ($125k/$2.5M).

Example of Increasing NOI & Steady Cap Rates: If NOI (based on example above) increases to $135,000 and the cap rate holds steady at 5%, the property value increases to $2,700,000 ($135k/5%). 

Example of Increasing NOI & Increasing Cap Rates:  If NOI (based on example above) increases to $135,000 the cap rate increases to 7.5% (due to sustained adverse economic forces impacting the rental marketplace), the property value decreases to $1,800,00 ($135k/7.5%). 

In a recession, you could see NOI decline due to higher vacancies and defaults.  A prolonged recession could also result in increased cap rates.  Below are two scenarios on how this could play out.

Example of Declining NOI & Steady Cap Rate:  If rent defaults and higher vacancy cause NOI to decrease to $115,000 & assuming the cap rate holds steady at 5%, the value drops to $2,300,000 ($115k/5%). 

Example of Declining NOI & Increasing Cap Rate:  If rents are down and the cap rate increases to 6.5% (due to a sustained drop in NOI in the market place), the property value drops even more to $1,769,231 ($115k/6.5%). 

CRE investors have to understand what is happening in the market, how the market forces are impacting NOI and cap rates, and where the market is headed.  As you can see from the examples above, several scenarios can play out.  Investors have to do their homework and put pencil to paper.  The decision to pull the trigger will depend on the investment goal.  If the goal is an exit based on steady or lower cap rates, then a market trending towards higher cap rates may not be right.  If an all-cash investor is looking for a high return on investment, then a market trending to higher cap rates may be ideal. You have to understand the numbers and market trends relative to goals in order to make the right decision! 

What does this mean for Business Bankers like you?  While everyone is telling you that the market is slowing and there are no deals to be done, you need to find those business owners that are looking for investment opportunities! These could be either owner-occupied or investor opportunities. If a business owner is on the fence about pulling the trigger on a larger building, you can show how the cap rate math works and might have a compelling argument that convinces the business owner to move forward! In firmly believe that there are deals to be done in any kind of environment.  You just need to know where to look and be ready to offer up valuable insight to help business owners make well-informed decisions! 

Bizpetrol has information, insight and tools that will help you become a Business Banking Superstar!  You can start elevating your business credit skills using the free Commercial Lending Toolkit at www.bizpetrol.com. You can see all the Business Banking articles (like this one) at www.bizpetrol.com/blog. You can access a series of how-to business banker guides at https://www.bizpetrol.com/Downloads-Free.

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