Property Values Will Get Double Lift When the Market Turns AroundOn the contrary, when the real estate market is strengthening, with rising demand, declining vacancy rates and increasing rents, cap rates are compressing. The cap rate compression in rising markets is due to the fact that investors consider that the risk of value declines is considerably lower, while there is an increasing expectation of significant property value gains ahead, as rents continue to rise. Within such an environment, investors are willing to buy at prices that imply lower initial income return, which is equivalent to the market capitalization rate. Lower market cap rates boost property valuations because according to the direct income capitalization approach, which is one of the widely-used methods for valuing income-producing property, value is equal to the ratio of net operating income (NOI) over the market cap rate, adjusted for the specific return and risk characteristics of the property under consideration. Thus, keeping the NOI of a property constant, a lower cap rate in the denominator of the direct income capitalization formula results in a higher property valuation. In a rising market, property values benefit also from increasing rents, which boost a property’s income earning potential and NOI. Again, taking into account the direct income capitalization formula, keeping cap rates constant, higher NOI results also in higher property valuations. The IMF predicts in its latest forecast that the economies of most countries will bottom out and enter in recovery mode in 2010 or 2011 the latest. Economic recovery will be a crucial factor in triggering property market recovery as well. The timing and strength of property market recovery will differ from country to country and even from location to location within the same country. However, when real estate markets start to recover, property values will get a double boost from rising rental rates and falling cap rates. From a strategic point of view, this means that investors, who will enter the market close to the bottom of this cycle, even without any discounts but at least at market prices, are very likely to achieve significant capital gains. Understandably, the speed of property value increases that will take place in each market will depend on the speed by which rental rates will be increasing and cap rates will be falling. The speed of rental growth will in turn depend on the strength of demand growth relative to supply growth in each market. The greater the difference between these two rates in favor of demand, the greater the speed by which property rents will be rising.
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