Prepare for a New Cap Rate Era

Though cap rates have mostly declined since 2000, market indicators suggest the declining cap rate era is ending and moderate cap rate expansion is likely, said RCLCO, Bethesda, Md.

“Successful real estate companies will adapt their investment paradigm to this new market context heeding the need to focus on operations, build organizational flexibility and leverage data in making informed choices,” RCLCO Institute Executive Director Eric Willett said in a special report, Ready for Changing Tides? How Real Estate Companies Can Prepare for a New Cap Rate Era.

Willett noted the past two decades have been a period of “dramatic and rapid” cap rate compression. Cap rates for institutional assets peaked at 8.4 percent in 2000; today, the same bucket of assets is appraised at a 4.4 percent effective cap rate. “The 400 basis points of cap rate compression has been a bonanza for investors across property types and geographies; the value of an identical cash flow stream has increased by 75 percent over this period even after accounting for inflation,” he said.

But these tailwinds are dissipating. “Most indicators suggest that the two decade-long era of persistent cap rate compression is at or near its end,” the report said. “For investors and operating companies, the departure from a market context in which cap rate compression is the norm demands an equally significant shift in the operating paradigm.”

This changing cap rate environment means real estate owners must change their method of value creation, the report said. To do that, owners should focus on operations, RCLCO said. “If cap rate compression can no longer make a deal work, successful companies need to build a competitive advantage through soft and hard product and service offerings that can command a premium,” Willett said.

Organizational flexibility also helps, Willett said. To prosper during a sustained period of flat or expanding cap rates, companies need to be able to shift resources to different organizational needs as the market changes. “Investment in developing strong asset and property management skillsets is especially impactful,” he said. “Organizations that have developed nimble structures and processes are best positioned to capitalize on these shifts.”

In the face of changing cap rates, developing enhanced rigor around investment and operational decisions will also help differentiate real estate companies, Willett noted. “Companies that effectively integrate systems to operationalize proprietary data and market data will be able to identify opportunities more quickly and adjust to adverse conditions in a way that best mitigates exposure [to them],” he said.