Definition
Cap rate compression occurs when capitalization rates decline, typically due to increased investor demand, lower interest rates, improved market fundamentals, or abundant capital. Because property value is inversely related to the cap rate, compression leads to higher valuations.
Valuation Relationship
Property Value = NOI ÷ Cap Rate
When the cap rate decreases while NOI remains constant, the property value increases.
Example
A property generates $1,000,000 in NOI:
- At a 6.0% cap rate → Value = $16,667,000
- At a 5.0% cap rate → Value = $20,000,000
The 100 basis point decline in cap rate results in a substantial increase in value.
Common Drivers of Cap Rate Compression
- Lower interest rates
- Strong economic growth
- Improving occupancy and rent growth
- Increased institutional capital inflows
- Perceived reduction in risk
Cap Rate Compression vs. NOI Growth
Value growth can come from:
- Operational improvement: Increasing NOI.
- Market repricing: Cap rate compression.
Investors often distinguish between value created through operations versus value gained from market expansion.
Risks of Relying on Compression
- Market reversal: Cap rate expansion can quickly erase gains.
- Interest rate sensitivity: Rising rates often pressure cap rates upward.
- Overpaying at peak: Buying into already compressed markets.
Investor Applications
- Exit underwriting: Stress-test reversion cap rates.
- Market cycle analysis: Identify compression phases.
- Relative value comparison: Compare cap rate spreads to Treasuries.
- Portfolio risk management: Monitor exposure to rate movements.