Property values are likely to get a double boost when real estate markets around the globe start to recover. This will happen because two key factors that affect the valuation of income-producing property will both move in a direction that will have a positive effect on values. These two key factors include property income and capitalization rates (or cap rates).
Analysis of historical movements of cap rates for commercial property has shown that cap rates move in a counter-cyclical fashion. In other words, when the real estate market is deteriorating with rising vacancy rates and falling rents, as is the case today for many real estate markets around the globe, capitalization rates tend to increase.
This makes sense because when the market is deteriorating the risk of property value declines is considerably higher. Given higher market risk, investors are requiring and are able to secure higher returns. Since capitalization rates represent the income return at the time of purchase, they tend to go up when market risk increases. The validity of this proposition is obvious today in many property markets, where cap rates have risen considerably due to the rapidly deteriorating market conditions in the last six months.
Under the same rationale, when the market is strengthening with declining vacancy rates and rising rents, cap rates tend to decrease. The reason is that in a rising market investors are more optimistic and they expect rents and property values to continue climbing. Given the lower risk of declining values and strong expectations for future capital gains, investors are willing to purchase property at prices that allow a lower initial income return, resulting in lower market capitalization rates.
Property values benefit from lower capitalization rates because, according to the direct income capitalization approach, property value can be estimated as the ratio of the property’s net operating income (NOI) over the market capitalization rate that applies to the specific property. Since the cap rate is in the denominator of this formula, it means that keeping the NOI of a property constant, the lower the market capitalization rate the higher the property value.
When the real estate market starts to recover, the values of income-producing properties will benefit not only from lower cap rates, but also from higher property income. A recovering real estate market is characterized by rising rents. Rising market rents increase the income-earning potential of a property resulting in a higher net operating income. As indicated earlier, net operating income is in the numerator of the property-value formula used by the direct income capitalization approach. Thus, keeping market cap rates constant, an increase in the net operating income of a property will result in a higher valuation.
Currently real estate markets around the globe are suffering the consequences of the global financial and economic crisis. The International Monetary Fund predicts that most economies will stabilize or return to growth by 2010 or 2011. The timing and strength of the economic and property market recovery will differ from country to country. However, when that time comes and real estate markets start to recover, property values are likely to get a double boost, as rental rates start to rise and cap rates start to fall.