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When Will Cap Rates Start Falling?

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By : Petros Sivitanides    99 or more times read
When will cap rates reach their peak and start falling? This is one of the key questions that real estate investors aiming at high returns need to answer in the current environment of rising capitalization rates.

This is a very important question because declining cap rates can trigger increases in property values and produce capital gains for investors that will enter the market at or close to the peak of the cap rate cycle. Such property value increases will take place as long as rental rates do not register further declines, which will counterbalance the positive effect of cap rate compression on property values.

Rising cap rates in an environment of falling rents, as is the case today, exaggerate property value declines and increase the risk of further capital losses. The rising cap rate trend in the United States is validated by the analysis of CoStar COMPs data gathered as of mid-March 2009, which shows that capitalization rates continue to rise across most markets in the United States.

Cap rates in the US are expected to continue climbing, putting additional downward pressures on commercial property values. According to the 1st quarter 2009 Korpacz survey of more than 100 institutional and private investors, capitalization rates are expected to increase by about 50 basis points over the next six months across all property types and most metro markets in the US. According to the results of the survey, capitalization rates for power centers, suburban office and regional malls are expected to register the largest increases, ranging from 65 to 74 basis points.

The results of this survey may suggest that it will take at least six more months for cap rates to reach their peak, but by no means provide a definite answer to this question. Based on the historical behaviour of the US commercial property market, capitalization rates will not peak until the tenant market starts showing solid signs of recovery with rising rents, strengthening absorption and declining vacancy rates. The recovery of the tenant market will depend in turn on the economic recovery, as rising employment, consumption expenditures and corporate profits will boost demand for commercial space.

According to the IMF March 2009 forecast, the US economy is expected to contract by 3-3.5% in 2009 and return to minor growth of 0-0.5% in 2010. This is similar to Moody's latest forecast predicting that the US economy will be declining in the first three quarters of 2009, resulting in a total contraction of 3.7% in Gross Domestic Product. Federal Reserve Chairman Ben Bernanke, according to a recent statement, puts also the US economic recovery in the beginning of 2010.

Based on the economic forecasts and investor surveys, it appears that cap rates in the US maybe several months away from their peak, but making accurate forecasts in this environment is extremely difficult. For this reason, investors need to carefully and continuously monitor developments in the economy and the real estate market, especially in terms of rents, vacancy rates and capitalization rates.

In general, it is important for property investors aiming at double-digit returns to develop a sixth sense in terms of understanding property market dynamics and the factors that trigger cap rate declines, since these are the kind of movements that produce capital gains and boost investment returns.
Dr. Petros Sivitanides, the author of Real Estate Investing for Double-Digit Returns, has a Ph.D. from M.I.T. and over 17 years of experience in real estate investment consulting, research and forecasting.

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