Capitalization Rate Influences and Property Value Increases1
by Petros S. Sivitanides, Ph.D.
Understanding the factors that affect capitalization rates can help evaluate developments in the real estate capital market and
assess their effect on property values and prices.
The capitalization rate represents a required or acceptable income return by investors looking for properties in the real estate marketplace. Within this framework, we can identify three major capitalization rate influences (see Figure 1):
a) Perceived risk associated with the investment under consideration,
b) Investor expectations for future property value increases (appreciation)
c) Required returns in alternative investment vehicles, such as stocks and bonds
Risk is the uncertainty associated with the future income stream and/or capital gains expected from the investment. For example, a government bond has zero risk, because there is no uncertainty regarding the income return on such an investment; the US Government guarantees interest payments on these bonds. On the contrary, corporate bonds are not considered as riskless since there is no guarantee that the company issuing the bond will be able to make the interest payments.
In real estate, risk can be defined as the uncertainty with respect to the property’s income-earning capacity and value. Investors’ risk perceptions regarding a property’s prospects should be influenced by the economic and real estate market conditions prevailing at the time of the purchase. All else being equal, one would expect that when the real estate market is strong, with rising rents, high levels of absorption, and declining vacancies, investors will feel less uncertain about the property’s future cash flows and appreciation prospects. This lower uncertainty will translate to a lower risk rating, allowing investors to accept lower returns and lower capitalization rates (see Figure 1). This proposition is supported by the findings of a study by Sivitanidou and Sivitanides (1999)2, who verified empirically that when market conditions are strong, office capitalization rates are low.
As we will see in an upcoming section, the performance of a property is affected not only by the broader market conditions but also by location and property-specific factors. These location and property-specific factors also affect risk perceptions and the capitalization rate an investor may use to calculate the maximum price he/she is willing to pay for a property. For example, an investor may consider a 30-year-old property as more risky than a new one. I can think of many reasons why that would be true, such as the greater risk of functional obsolescence or greater overruns of maintenance expenses (beyond those normally accounted for buildings of this age).
Other location-specific factors that may affect an investor’s risk perceptions have to do with the stage of development of an area. An investor may consider the purchase of a property in an area with little development, infrastructure, and supporting services as more risky, compared to a property located in a fully developed neighborhood. The former may have greater value appreciation potential, but if the neighborhood is in the early stage of development, there is also greater uncertainty as to whether development will intensify, and when. That is why new massive development in a mostly undeveloped area will decrease the risk of existing properties and contribute to decreases in the cap rate investors use to estimate the price they are willing to pay for such properties.
Sivitanidou and Sivitanides (1999) 2 have confirmed the influence of another factor, which can be linked to the perceived risk of real estate investments. This factor has to do with the diversity of the local economy as it relates to the property market under consideration (office, retail, industrial). For example, the term “diverse office markets” refers to markets in which office employment composition is uniformly spread throughout several economic sectors, as opposed to only a few sectors. The argument is that non-diverse office markets are more risky; if the sector in which most of the market’s office employees are active takes a hit, there will be a significant negative effect on local office space demand, leading to declines in property income and values. Sivitanidou and Sivitanides found a strong statistical relationship between high diversity in an area’s office tenant base and low capitalization rates. They also verified that markets with stable office-employment growth rates tend to have lower capitalization rates. Within the theoretical framework developed so far, this effect can only be linked to investor risk perceptions.
Another factor that may affect the investor’s required income return, and therefore, the capitalization rate, is expected appreciation. Investors make their decisions based on total expected return, which on an annual and unleveraged basis it is equal to the sum of income return and appreciation return, per the calculation method applied by the National Council of Real Estate Investment Fiduciaries (NCREIF). The relationship between the two becomes less simplistic in the context of a muli-period discounted cash flow analysis. In any case, however, all else being equal, an investor epxecting higher appreciaton return from a property investment should be willing to accept a lower income return, and therefore a lower capitalization rate. Conversely, all else being equal, lower appreciation return expectations should motivate investors to require a higher income return implying a higher capitalization rate.
The bottom line is that when market-wide expectations of value increases are high, market capitalization rates should be low; when the expectations for value appreciation are low, capitalization rates should be high. Notice that investor expectations regarding the future appreciation of a property are influenced by the same factors that influence risk perceptions, that is, indicators of market strength (see Figure 1).
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