The Benefits of Investing in a Low Cap Rate Market

One of the most important valuation metrics in real estate is the Capitalization Rate, or “Cap Rate” for short. There are many ways investors can benefit from using Cap Rates, from valuing properties to determining the additional value that will result from investing additional capital to renovate or otherwise improve an existing property.

In this article, we look at how Cap Rates work and the benefits to investing in a low Cap Rate market like Southern California compared to other U.S. markets that may have higher average Cap Rates.

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What is Cap Rate?

In real estate, the Cap Rate is the unleveraged or cash yield (i.e. the net operating income or NOI) of a property in relation to its purchase price or value at a point in time. For initial investments, the Cap Rate is expressed as the “current return” - the percentage return on the initial investment. The Cap Rate can also be considered to mean the unleveraged cash yield on investment that investors require for comparable properties in a particular market.

The Cap Rate for a real estate property is calculated as follows:

Cap Rate = Net Operating Income (NOI) Divided by the Property Purchase Price or Value at a point in time.

For example, if a property is generating $1 million of NOI at the time the Property was purchased for $20 million, the Cap Rate would be 5% (1/20). If a property is generating $1 million of NOI and purchased for, or valued at, $25 million, the cap rate would be 4% (1/25).

What Factors Influence Cap Rates?

Many factors influence cap rates and, collectively, tend to fall into three categories:

1. Capital Markets

The unleveraged cash yield offered by alternative investments with a similar risk profile have the greatest effect on Cap Rates. When interest rates rise, Cap Rates tend to follow suit.

When the yield on fixed-income investments, such as bonds or Treasuries, rise, Cap Rates for real estate will also typically rise. For example, if Cap Rates for properties such as apartment buildings in a typical market were 5% when similar duration fixed income investments were yielding less than 5%, investing in apartment buildings can be a compelling investment opportunity due to their greater initial yield combined with growth potential.

On the other hand, if fixed income investments were yielding greater than 5% due to rising interest rates, possibly with lower risk than an apartment investment, a 5% yield on an apartment investment becomes less compelling, causing investor demand for apartments to fall and resulting in lower property prices as investors require a greater initial yield (Cap Rate) for such investments.

The availability and cost of capital has arguably the largest impact on Cap Rates. In a low interest rate environment, when fixed income investments are generating lower yields than real estate, investor demand for real estate is typically quite robust, causing Cap Rates to fall and prices for real estate to rise. Borrowing also plays a part as most investors typically borrow a portion of the purchase price to acquire a property.

If the property yields 5% and the interest rate on the debt used to purchase the property is less than 5%, this is considered “positive leverage”, as the leveraged cash flow from the property will be greater than the Cap Rate of 5%. On the other hand, if the interest rate on the debt is greater than the 5% Cap Rate, the result is “negative leverage” as the leveraged cash flow from the property is less than the 5% Cap Rate. Of course, over time, this negative leverage may disappear as cash flow from the property increases, so initial negative leverage may turn into positive leverage over time.

Virtually every investment is ultimately tied to a risk premium over a “risk-free” rate of return. The standard proxy for the risk-free rate is the interest rate on U.S. Treasuries. So, if interest rates for U.S. Treasuries rise, capital will flow to Treasuries unless the returns offered by other riskier investments rise as well.

This is how the risk premium is maintained. In real estate, there is always a discussion of the spread between U.S. Treasuries and Cap Rates. That spread can expand or contract at different stages of a cycle, depending on the demand and supply of capital for a particular investment or type of investment.

2. NOI Growth Expectations

As noted above, Cap Rates are in part a function of NOI. Investor perceptions about the extent to which an investment will generate future growth in NOI also impact its Cap Rate and, thus, the value of the investment. An investment that is likely to have a higher growth rate in NOI than an alternative investment will trade at a lower Cap Rate, all other things being equal. In other words, an investor will accept a lower initial Cap Rate in return for the likely prospect of future growth in NOI.

There are several things that can impact growth expectations about future NOI. For example, supply and demand in the marketplace can play a role, as can the product type. An asset may have certain competitive attributes (e.g., strategic location, unparalleled amenities, newly built, etc.) that make it worth more than other nearby somewhat similar properties.

3. Risk

Properties are also subject to various risk factors that can influence future NOI and, thus, asset values. An individual asset may have competitive weaknesses—for example, age leading to future required capital investment, or changing neighborhood demographics.

Structural forces can also impact value. Just look at what Amazon has done to Main Street retail. Similarly, the pandemic has crushed certain traditional office space. These two structural forces have impacted some property types more so than others. For example, predicting future growth for most retail and office buildings is quite risky, leading to a significant increase in Cap Rates for these product types.

Should We Be Afraid of Low Cap Rates?

Investors have differing opinions as to whether or not a low cap rate is a good thing. In general, markets with low cap rates are high demand investment markets with better than average future growth expectations - the trade-off for the lower initial Cap Rate. However, since the future is always more risky than the present, many investors may prefer higher initial returns (Cap Rate) in markets where future growth may be much more limited.

Low cap rates are not inherently good or bad. It really comes down to both understanding what’s driving a property’s Cap Rate; and jjthe investor’s appetite for risk and return.

For example, some commercial real estate investors are always afraid of low cap rates. They believe low cap rates limit their cash flow and puts their upside potential at risk.

In some markets, and with some business strategies, that’s a legitimate fear.

Consider an investor who buys an asset in a low cap rate market that has significant supply-side risk. This might be a Sunbelt city where there is a lot of affordable, developable land nearby. It might be in a municipality where there are few regulatory barriers to new construction. Existing assets are therefore not priced at a large discount to replacement cost.

In a situation like this, new supply might limit the growth of (or even reduce) operating cash flow and thus, the asset’s appreciation potential. In turn, the cap rates on existing prices will rise given fears over lower rent growth expectations and higher perceived risk.

Similarly, someone who buys a stabilized asset in a low-cap rate market must be extremely confident that everything will work in their favor. Debt must be readily accessible at low rates; rent growth must continue as anticipated during the underwriting process; and the potential risks never materialize. Otherwise, cap rates will inevitably rise and asset values will come down accordingly.

This is what exactly what we’re seeing play out today in many commercial real estate markets. Investors who purchased assets at exorbitantly high prices (read: low cap rates) over the past few years are now feeling the impacts of the market correction.

However, thoughtful value-add investors will find that there are still opportunities to increase revenue even in a low cap rate environment. At Paladin, we have experienced this first-hand by investing in Class B and C multifamily properties located throughout Southern California.

How to Benefit from Low Cap Rate Markets

For value-add investors, certain low cap rate markets offer an exceptional investment opportunity—even during times of economic uncertainty.

At Paladin, we look for strategies where there is an asymmetrical relationship between risk and reward. Namely, investments that offer a combination of significant upside potential (i.e., higher rents and property appreciation) with very little downside risk during a market downturn.

Let’s dig deeper.

For nearly 30 years, Paladin has been investing in Class B/C apartment buildings in Southern California. We’ve been doing this even though the SoCal cap rates are some of the lowest in the nation (sometimes as low as 3% to 4%).

With cap rates so low, why are we still pursuing deals here?

There are a few reasons.

Los Angeles County is a major gateway metro home to more than 10 million people. It has a large, dynamic economy yet there is insufficient housing to accommodate all of the people who want or need to live here. Most of the area’s multifamily housing consists of low-density, garden-style apartment buildings that were built just after World War II. Today, land costs have skyrocketed making it less economically feasible to build new housing. That, combined with regulatory barriers to new development, work to constrain the housing market even further.

We see this as a huge opportunity.

Class B/C apartments provide an essential need. This is the “workforce housing” that remains relatively affordable, especially when compared to the Class A alternatives. It is also clustered around major employment centers, which makes it especially attractive to the local workforce.

This provides Class B/C apartments with several competitive advantages:

There is a huge cost advantage compared to new construction. These buildings typically trade at 50%+ discounts to replacement costs. This is true even after renovation costs have been factored in.
These assets have strong pricing power. This is largely because we look to buy properties with a large “loss to lease” – i.e., a building’s current rents on existing leases are below market rents by 20% to 30% or more. This allows us to incrementally increase rents, even during a downturn, while still providing below-market rents.
Given the above, we tend to have “sticky” tenants. People don’t want to leave their below-market apartments and therefore, we experience very little vacancy. When tenants do vacate, units re-lease quickly given the size of the local population and demand for this type of housing.
Tenants are part of what’s become a “permanent renter class”. SoCal housing prices have climbed beyond the reach of most residents. People who would have rented for a few years before buying their own home now realize that may never be a possibility. Instead, they are part of a permanent renter class (i.e., renters by necessity) who have few other housing options.

Collectively, these competitive advantages provide unparalleled downside protection, especially during market downturns.

Will SoCal Cap Rates Rise?

Apartment buildings in Southern California have historically traded at relatively low cap rates compared to other U.S. markets. Some may wonder how long this can be sustained. However, relative to other U.S. markets, the prospect for continued low cap rates in this asset class remains high.

This is an important distinction.

This is not to say that SoCal apartment cap rates won’t rise. They’re already rising due to higher interest rates, and likely will continue to rise through 2023. However, relative to other U.S. markets and other product types, SoCal apartments are expected to trade at the lower end of the cap-rate spectrum for the foreseeable future.

Value-add investors who know how to increase cash flow in this low cap rate environment, like we have been doing for the past 30 years, will find the upside potential to be very rewarding.

Consider this: for every additional $1 in cash flow, this translates into $20 to $25 in incremental value in a 4% to 5% cap rate market like we have in Southern California. When combined with conservative leverage, the returns offered by this value-add strategy can be highly attractive.

The Bottom Line

In Southern California, Class B/C apartment buildings continue to exhibit an asymmetrical risk/reward proposition that continues to offer tremendous upside potential even in a low cap rate environment. Meanwhile, the downside protection is unparalleled given the unique attributes of Class B/C workforce housing in and around Los Angeles.

This isn’t speculation. We’ve seen this come to bear time and time again.

Paladin has made 90+ apartment investments across the U.S. totaling $800 million, with more than half of these concentrated in SoCal. Our SoCal portfolio continues to be among the best performing in the company’s 30+ year history. This is true despite assets trading at low cap rates. Indeed, for skilled investors, there are tremendous benefits to investing in a low cap rate market.