Cap Rate Cycle

According to empirical evidence presented by Sivitanidou and Sivitanides (1999) movements in capitalization rates are influenced by both real estate market fundamentals and capital market fundamentals. Empirical evidence has shown also that there is a real estate market cycle, which is manifested in cyclical movements of rents and vacancy rates from low to highs and vice versa. Wheaton (1987) has documented this cycle in the office market.

Real Estate Cycle

The decrease in rents, when it reaches sufficient levels, will have two effects. On one hand, it will trigger increases in demand and, on the other hand, it will discourage developers from completing and putting more space in the market. As a result of these adjustments, which do not happen instantly but through time, vacancy rates will start gradually declining. According to theory, rents will continue to decline until the vacancy rate decreases to a level referred to in the literature as structural or normal vacancy rate, which is considered as the minimum vacancy rate required in the market in order to allow normal search processes both on the part of buyers/renters looking for space and landlords/sellers looking for tenants/buyers. That is the level at which theoretically demand for space is equal to the supply of space.

Any further decrease of the vacancy rate below this level denotes that demand exceeds supply, a situation that according to conventional economic theory should trigger increases in rents. Due to sluggish adjustments of supply in responding to the higher levels of demand, rent increases continue for a while before the market comes back to balance. It should be noted though that due to the dynamic nature of the economy and the fluctuating demand growth rates, as well as the difficulty of suppliers in anticipating correctly the level of demand that will prevail when their projects will be completed, the real estate is rarely at equilibrium.

Cap Rate Cycle

Looking at the cap rate cycle and the real estate cycle strategically, the conclusion is that property investors that buy at the bottom or near the bottom of the cycle will be able to realize significant capital gains or high appreciation returns because values will benefit both from rising rents and declining capitalization rates as the market recovers and rents move to their peak.

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