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Inside Plato’s Cave: thinking about cap rates

by Randall Zisler and Matthew Zisler

The Allegory of the Cave, or Plato’s Cave, involves a group of people who have lived chained in a cave all of their lives, facing a blank wall. The people watch shadows projected on the wall by things passing in front of a fire behind them, and begin to ascribe forms to these shadows. But, according to Plato, these shadows do not constitute reality at all.

In a similar vein, cap rates are like two-dimensional shadows of three-dimensional objects on the wall of the cave. Therein, piercing this limited dimensional view is one of the challenges, and conundrums, of market analysis.

Cap rates are not as volatile as corporate bonds, whether AAA or below investment grade. In fact, cap rates exhibit a very low correlation with government and corporate bonds; cap rates also have a low correlation with inflation. Specifically, for the period 2002 through 2014, the correlations of 10-year Treasuries and inflation with cap rates are only weakly positive, 0.28 and 0.02, respectively.

Why is this important? Many real estate professionals, especially sales brokers eager to stimulate sales volume, believe (incorrectly) that rising interest rates will necessarily increase cap rates and thereby reduce property values. During the past five years, the so-called wise heads, within and outside of the real estate profession, have predicted rising interest rates and inflation; due to near deflation and falling interest rates, the markets have confounded these forecasts. The double supposition was, first, that interest and inflation rates would necessarily increase even though actual GDP underperformed potential GDP during this period, and second, that cap rates would rise a fortiori. In fact, cap rates have fallen dramatically and continually since 2009.

The cap rate, by itself, is meaningless at best and confusing and misleading at worst. The reason is that there are many factors that determine the cap rate. A cap rate, which is the ratio of net operating income (NOI) divided by the total purchase price (or market value, if appraisal-based), is equal to the sum of the risk-free interest rate and the credit spread (expected cost of capital), minus the expected rate of growth of net operating income. The cap rate is not the cost of capital. Otherwise, if it were, the cost of capital of unleased land would be less than the rate at which the U.S. government borrows. (Note that value is a function of cash flow, which, unlike NOI, includes leasing and capital expenditures.)

The data do not support the proposition that for every 1 percent increase in interest rates, cap rates will necessarily increase by up to 1 percent. The theory explains why this is the case. Cap rates reflect many — at times offsetting or amplifying — factors. For example, in a booming economy with strong underlying fundamentals, the risk-free interest rate may rise and credit spreads narrow while expected NOI growth increases, thus depressing the cap rate (and increasing prices). Similarly, in a recession, the risk-free rate may fall (due to accommodative monetary policy) and credit spreads widen due to heightened uncertainty while expected NOI growth declines. In such a scenario, cap rates would rise.

The recent five years would illustrate a hybrid scenario of rapidly falling cap rates accompanied by a falling risk-free rate, narrowing credit spreads and rising expected NOI growth.

What can we expect over the next few years? Interest rates now remain low, but what about credit spreads and NOI growth? A plausible scenario is that GDP growth, heretofore sluggish, increases substantially, thus strengthening expected NOI growth and reducing credit spreads, even though heightened competition for capital in a stronger macroeconomy increases the risk-free rate. In such an example, depending on the path of credit spreads, cap rates could increase (prices decline), remain stable or decrease further. We just do not know for sure, but investors act today as if they believe the second and not the first story.

The extensive research literature supports the following additional insights regarding cap rates:

•  Cap rates vary across (and within) cities and property types and the reasons for this variation are many and complex.

•  The dispersion of cap rates at any one time for seemingly similar properties is surprisingly significant; hence, investors should be sensitive to one-size-fits-all reductionism. The simplicity of the cap rate formula hides more than it reveals, and that which it hides may be important.

•  The cap rate is not the cost of capital, unless the expected growth rate of NOI is zero.

•  Cap rate changes, taken in isolation, may not reveal much about value, the path of property prices or the state of the underlying markets.

•  To apply average national prevailing cap rates to current NOI can produce unreliable and surprising results, especially in those cases involving multi-tenanted properties or properties subject to special features — financial, physical or economic. Cap rates are static, not dynamic. In particular, two properties with identical cap rates may react quite differently to exogenous shocks if embedded options or lease structures vary between the properties. Cap rates will not reveal these important features.

•  Market changes affect cap rates with a considerable lag; cap rates exhibit low, and possibly excessively low, volatility.

The high priests of real estate who populate conferences and fill the trade magazines with glib, unexamined opinions often do not understand cap rates; these experts’ pronouncements seem to generate more smoke than light. Now is the time to open the windows, drive the priests from the temple steps and throw the spotlight on the reality of cap rates.

Is it not time investors emerged from Plato’s Cave?

Randall Zisler is chief investment officer of Encore Enterprises, Inc. and Matthew Zisler is senior managing director of Encore Institutional Capital, LLC.

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