Definition
Cap rate compression occurs when capitalization rates decline, resulting in higher property valuations.
Cap rate expansion occurs when capitalization rates rise, resulting in lower property valuations.
Valuation Mechanics
Property Value = Net Operating Income (NOI) ÷ Cap Rate
Because cap rate appears in the denominator, small changes can significantly impact property value.
Example
NOI: $1,000,000
- At 5% Cap → Value = $20,000,000
- At 6% Cap → Value = $16,666,667
A 1% increase in cap rate reduces value by over $3 million.
Causes of Cap Rate Compression
- Lower interest rates.
- Strong investor demand.
- Improved market fundamentals.
- Reduced perceived risk.
Causes of Cap Rate Expansion
- Rising interest rates.
- Economic uncertainty.
- Increased risk premiums.
- Declining property fundamentals.
Impact on Returns
- Compression increases exit value and boosts IRR.
- Expansion reduces resale value and compresses equity returns.
- Leverage magnifies both effects.
Market Cycle Considerations
- Early expansion phases often see compression.
- Late-cycle or tightening environments may see expansion.
- Interest rate movements strongly influence trends.
Underwriting Strategy
- Use conservative exit cap rates.
- Stress test multiple cap scenarios.
- Avoid relying solely on future compression.
- Focus on NOI growth as primary value driver.
Common Pitfalls
- Overpaying based on assumed compression.
- Ignoring macroeconomic risks.
- Underestimating impact of rising debt costs.
Investor Checklist
- Analyze interest rate environment.
- Model exit cap sensitivity.
- Compare going-in cap vs exit cap assumptions.
- Evaluate long-term demand fundamentals.