Interest rates, cap rates, and apartment investments

It looks like cap rates for commercial properties have remained steady even though interest rates are firming up. 

Interest Rates Aren't Affecting Cap Rates (National Real Estate Investor Magazine)

For an investor, this is a crucial relationship to watch and understand.

There are (at least) two different interest rates to consider. The first is that of Treasury bills, which has a profound effect on investments, economic growth, and the federal budget. The second is the interest rate a buyer of an apartment building pays to borrow.

Business growth of the general economy may be the most important factor for an owner of commercial real estate. The ten year Treasury bill competes for the attention of investors; commercial real estate, with its work, risk, and tax results must offer a premium to an investor over the no-risk T-bill. That "spread" has been historically high recently. A researcher at CoStar Inc. estimates that, if the T-bill goes up 1%, cap rates will increase a half-percent. The market value of a property goes down (cap rates are the "net operating income" divided by the "price" of the property. If the cap rate goes up, and the NOI remains the same, the "price" must be less).

Higher interest rates harm the financial return of an individual investor buying an apartment property, since their interest carrying costs reduce their net cash flow. Less buyer net cash flow means a lower property value (to that investor).

So, what to do? See the next article....