Cap Rates and Interest Rates in Commercial Real Estate

Investing in commercial real estate requires forecasting current and future performance. This involves many variables, but for today’s discussion, we want to focus on two important metrics: cap rates and interest rates. As an investor, it’s imperative to pay close attention to the movements in these two metrics since they impact commercial real estate investment performance.

What is the Cap Rate?

Cap rate, also known as capitalization rate, is used in commercial real estate to determine the rate of return that is expected to be generated on an investment property, if purchased without leverage. It describes the relationship between a property’s Net Operating Income (NOI) and its market value. The formula used to calculate the cap rate is:

Net Operating Income = Total Income – Operating Expenses

Capitalization Rate = Net Operating Income / Purchase Price

Cap rate is a basic calculation for how real estate investments are valued in the marketplace. If there are lower cap rates, it generally means that the property is less risky, and the asset price is high. Conversely, the higher the cap rate, generally the greater the risk and potential return. Lower value cap rates typically indicate the property is steady and has reliable growth, a characteristic commonly seen in multifamily properties. Higher cap rates imply relatively lower prospects of return on property investment and are therefore considered riskier investments.

What are Interest Rates?

Interest rates are the amount charged by a lender to a borrower and can have a profound effect on the value of income from real estate investments. If interest rates are low, the bank will earn less on the loan issued and a borrower will pay less to obtain the loan. When rates are high, a bank earns more, and a borrower pays more. Higher interest payments reduce your net cash flow and investment returns, which is called the cost of financing.

When it comes to investing in commercial real estate, there is one type of interest rate benchmark that is important to track, risk-free rate. That is the rate paid on a bond issued by the U.S. Department of Treasury with a 10-year maturity. It is called the risk-free rate because it is considered the safest place to put money and investors can be confident that they will be repaid, with interest, on time. However, in comparison to investment returns on commercial real estate, the return on investment is low.

As an investor, how much more risk are you willing to take in order to capture higher returns? This is where the relationship between cap rates and interest rates comes into play.

The Relationship Between Cap Rates and Interest Rates

Commercial real estate cap rates and interest rates are historically highly correlated and understanding the relationship between the two can give you insights into the market. As interest rates go up and down, cap rates also go up and down. Both are not static, which means both are constantly changing, impacting real estate valuations. Economic conditions and investors' demand are factors that drive changes in the 10-Year Treasury rate. During economic setbacks, investors tend to lean toward the safe side and use Treasuries, which drives prices higher and rates lower.

Cap rate changes are driven by numerous factors, but the most prominent are supply and demand expectations. When there is a low supply and high demand, investors will accept a lower return because there is a lower risk. Cap rates fall and prices rise, meaning investors are willing to pay more for potential growth. So, depending on the economy, the spread between treasury rates and cap rates expands and contracts. When the spread is at a high, it means the potential return may be higher, but if it is a lower spread then it is a lower return.

Invest with CF Capital Today

The relationship between interest rates and commercial real estate can significantly impact property values. That’s why it’s important to strategically monitor changes in interest rates and how it might impact the market. At CF Capital we carefully research and due diligence, to find investment opportunities that offer the potential for high returns even in today’s current market. When you passively invest alongside our team, you can have confidence we are closely monitoring and optimizing these factors for your real estate investment success.

Real Estate vs Stocks: Which is a Better Investment?

The two most popular investment vehicles are real estate and stocks, both of which can offer lucrative profits. As an investor, you are looking to grow your future wealth and ideally, you should consider diversifying your portfolio and investing in both. But investing in both is sometimes not possible, especially with the current economic state, and there are strategic considerations such as the weighting of your allocations. So, why should you invest in real estate vs stocks? Here are just 4 reasons why:

Real Estate vs Stocks: The Rundown

Real Estate is More Stable than Stocks

Real estate is generally more stable and easier to predict than the rather volatile stock market. While it’s not immune to the market cycle, the value of real estate has historically appreciated. Since real estate profits steadily increase over time, they can act as a hedge against inflation. This is because housing is a constant need and is considered a consumer good, and inflation can increase the price of consumer goods. Cash flows usually keep pace with inflation: as the cost of living grows, so does the market price for rent.

In the stock market, dramatic fluctuations can take place daily and losses can be significant, making investing in real estate a lower risk than the stock market. Stock markets can be a struggle to predict, even for investment professionals. A significant drop in the market can reduce your principle and if it is significant enough it could take years to recover your original investment.
Return on Investment

Typically, in the stock market, you make money by buying low and selling high, but most investors can’t do this consistently. Real estate practically guarantees ROI if you invest with prudence. Commercial real estate offers continuous value because you are dealing with individual properties that vary in features, location, size, and more. By locating and acquiring properties at a discount versus their market value, creating additional value, and optimizing operations, real estate can be a terrific vehicle to create very attractive ROIs. Investing in real estate gives you more nuanced opportunities to build on your wealth.
Commerical Real Estate: Source of Income

Commercial real estate is the type of investment that you can live on. Revenue from commercial real estate can be used to pay down debt or cover expenses associated with the property including mortgages, taxes, insurance, maintenance, etc. Unlike stocks, commercial real estate can have a day-in, day-out value in the form of cash-flow income that stocks typically cannot match. Commercial real estate properties can increase your personal cash flow if selected well.
Real Estate is a Controllable Investment

Your investment is important to you, so why invest in an uncontrollable stock market? Trying to time the market is nearly impossible, even for experienced investors. But with real estate, timing the market is more likely due to the overall inefficiencies in the market. The real estate industry is historically more stable and predictable than the stock market. Real estate is not affected by a company making poor decisions or committing fraud. Though real estate doesn’t exactly protect you from the economic cycles, it gives you leeway to make more stable profits.

Real estate isn’t something where you can go into and expect immediate results and return. But with an experienced team, you can be sure that you are making the right investments. The current economy has investors concerned, however, our team at CF Capital leverages our expertise and is dedicated to helping our current and future real estate investor partners. Get in touch with us today and learn about how you can passively invest with our experienced team!

The Two Types of Inflation: What You Need to Know

Inflation refers to the rising prices of goods and services, which typically happens gradually, however, the current inflation rate is far from gradual. At the time of this writing, the country is dealing with two types of inflation: demand-pull inflation and cost-push inflation, both influencing your purchasing power. Let’s discuss these types of inflation, the conditions that cause them, and how investors like you can hedge against them.

What is Demand-Pull Inflation?

Demand-pull inflation is the most common cause of inflation. It occurs when the aggregate demand for a good or service exceeds the aggregate supply. Sellers can meet that increase with more supply, but if the additional supply is unavailable, then the sellers can raise their prices. If something is in short supply, sellers will generally ask people to pay more for it.

There are a few reasons why demand-pull inflation occurs, this includes:

Growing economy: When the economy is booming and unemployment is low, consumers typically earn and subsequentially spend more money. This drives up aggregate demand throughout the economy, which can lead to higher prices.
Government spending: Government response to economic conditions, including providing a stimulus during the economic downturn or providing tax breaks can impact how much money people spend on goods and services. When the government spends more freely, prices typically go up.
Inflation expectations: Inflation expectation refers to the rate at which people expect prices to rise in the future. When consumers expect inflation soon, they tend to start buying more now to avoid paying higher prices later.

What is Cost-Push Inflation?

Cost-push inflation is a result of supply conditions, rather than demand. It occurs when the costs of delivery products or services increase, but demand is unchanged. Cost-push inflation often happens alongside demand-pull inflation. When raw materials prices increase, then businesses raise their prices to maintain profit margins, regardless of the demand.

For example, let’s say you love steak tacos from your favorite restaurant, but the price of beef keeps going up. Eventually, they will have to raise the prices of their tacos regardless of demand.

Another cause of cost-push inflation includes increased labor costs. This happens when there is a mandatory wage increase for production employees causing product prices to increase. Also, a work strike will likely lead to a decline in production. Natural disasters and government regulations can also make an impact.

How You Can Hedge Against Inflation

Inflation is a decrease in your purchasing power and the decrease in the value of each dollar in your pocket. This means it takes more money to buy the same product, asset, or investment. A growing economy will bring with it steady inflation, but economists and consumers prefer to see prices rise slowly, unlike what is happening now. When inflation increases faster than usual, consumers tend to worry about paying higher prices for gas, groceries, rent, and other products and services.

Fortunately, there is a way to hedge against today’s current inflation, and that is investing in multifamily properties. Though any investment property can be a good hedge against inflation, investing in multifamily provides more protection due to the nature of the asset. Generally, rents reset every 12 months, and rent typically outpaces inflation. Those who live in multifamily communities are obligated to their lease, and over time the rent (and other income generated) can pay for the investment itself plus excess cash flow.

Though inflation is currently rampant and at a historically high rate, you can use real estate to hedge against inflation to protect your capital and purchasing power, along with so many other financial benefits. At CF Capital, our experienced team can help you invest in the future. So, if you are ready to explore your options to passively invest in real estate, get in touch with us.

Capital Appreciation: Evaluating Performance of Real Estate Investments

If you are new to the world of real estate investing, it won’t take long to come across a lot of different industry specific terms such as capital appreciation. This term may seem confusing and daunting at first, but the good news is we are here to explain what it is and how to implement it in your investments.

What is Capital Appreciation?

By nature, the market value of investments changes over time with prevailing market conditions. When the value of your investment increases, there is appreciation, and when the value of your investment decreases, there is depreciation. Simply defined, capital appreciation is when the market price of real estate rises. It is the difference between the initial purchase price and the eventual selling price of an investment. It is used to determine the performance of real estate investment. It happens when the price of a stock, the property worth of a home, or the value of your real estate grows. For example, if you pay $1,000 for a stock investment and its price increases to $1,500, you could say that the investment has appreciated by $500.

Here are two important definitions that are connected to capital appreciation:

Cost Basis: Cost basis is the context of commercial real estate. It’s the original purchase price of investment property and any out-of-pocket expenses or closing costs related. Consider this scenario: you bought a rental property for $500,000 which is now worth $550,000. Sounds like a $50,000 gain, right? Not exactly. Keep in mind, during the closing you might have paid $10,000 for title insurance and another $10,000 in loan fees. This means your initial basis in property is $520,000 and your gain is $30,000.

Market Value: Market value is the sales price of a property in the market if you were to put it on the open market. Market value is usually determined by the market through a combination of comparable sales, projected rebuild costs, and the income approach. Generally commercial real estate, including large multifamily investments, are valued with an emphasis on the income approach, via the market capitalization rate derived from the Net Operating Income (NOI) of the asset.

Capital appreciation is different from income and total return. Income is the money that is paid out from owning an asset, such as operating expenses and debt service. Your total asset return is defined as a combination of capital appreciation and ongoing cash flow.

How Commercial Appreciation is Calculated

There are two ways to go about calculating capital appreciation: either by dollar amount or as a percentage.

Dollar Amount

Calculating a capital appreciation dollar amount involves subtracting the cost basis from its market value. For example, let’s say your real estate’s cost basis is $200,000 and the market value is $230,000, the formula for your capital appreciation would be:

Cost Basis - Market Value = Capital Appreciation

$230,000 - $200,000 = $30,000

The capital appreciation is $30,000.

Percentage

When calculating a capital appreciation percentage gain or loss, take the dollar amount of your capital appreciation, then divide it by your cost basis, and then multiply by 100.

Let’s take the example from above. Your basis is $200,000, your market value is $230,000, and the dollar amount of your capital appreciation is $30,000. Here is the formula:

(Capital Appreciation/Cost Basis) x 100%

($30,000/$200,000) x 100% = 15%

The Importance of Capital Appreciation

Capital appreciation is important for you as an investor to be aware of and fully understand. Every commercial real estate investor needs to consider capital appreciation when planning their investment property strategy to get the most out of their investment. Capital appreciation provides one of the best ways to make a large return on their investment.

CF Capital is here to support you in achieving your real estate investment goals. We are a national real estate investment firm that focuses on acquiring and operating multifamily assets that provide stable cash flow, capital appreciation, and a margin of safety. Contact us today and learn about our passive investment opportunities!

The Uncommon Path: Let’s Talk About Being a Contrarian….

“One must avoid snobbery and misanthropy. But one must also be unafraid to criticise those who reach for the lowest common denominator, and who sometimes succeed in finding it. This criticism would be effortless if there were no "people" waiting for just such an appeal. Any fool can lampoon a king or a bishop or a billionaire. A trifle more grit is required to face down a mob, or even a studio audience that has decided it knows what it wants and is entitled to get it. And the fact that kings and bishops and billionaires often have more say than most in forming appetites and emotions of the crowd is not irrelevant, either.”

― Christopher Hitchens, Letters to a Young Contrarian

By definition, a contrarian is someone who opposes or rejects popular opinion. We think, perhaps a better way to put it is: a contrarian mindset might not be about opposing the crowd, but to think for oneself. It’s not in what one thinks, it’s how one thinks.

We acknowledge and can directly relate to the notion that being a contrarian can be uncomfortable for some, while he or she is daring to be different. Figuratively speaking, it means standing away from the crowd, all alone at times.

With that said, we firmly believe that “comfort is the enemy of progress,” as P. T. Barnum once said.

Do you think that you would see any of the incredible advancements in technology today if everyone stuck with the status quo and agreed with the popular thought at the time?

Contrary to one’s immediate belief, in being a contrarian, you open up a wide range of possibilities and a better chance to capture incredible opportunities. A contrarian is not limited. A contrarian is freed from shackles of constrained thinking.

What are the factors that dissuade independent thought? Is there actually something to be said for the wisdom of crowds or is the explanation to be found in less “clever” attributes? Studies and insights from psychology, behavioural economics and other disciplines offer some useful clues as to why the herd is so large and, by extension, why contrarians can bring such value.

For example, at the core of recent research done in the field of psychology, is the contention that the human brain is innately lazy. Heuristics, the mental shortcuts we employ to form judgments, are one symptom of this weakness.

We are definitely (or at least we think we are) not individuals that are naturally lazy. In fact, I don’t think our brains will let us.

At CF Capital, we are always thinking about how we can do things better. We constantly remind ourselves to be skeptical of any “fact” that becomes conventional wisdom. By necessity, remarkable performance at a firm and investment level will always accrue to a minority; so by design, we try to seek out situations when dominant narratives are inaccurate. Kind of like uncool (but talented) kids that get picked last in school playgrounds.

But moving on from our rant about contrarian philosophy, you might ask, “how do you apply this to what you do as a firm?” For the sake of being concise, we have provided some examples in bullet-point form:

We seek out investment opportunities where most wouldn't dare to go. We do enjoy the thrill of finding the hidden gem and “love swinging at fat pitches”, but we do not let that overpower our primary mission.
We are careful, patient, and thorough. We let our depth and craft guide us to greater performance in both business and investing. Our out-of-the-box thinking is immediately evident in how we navigate the investment process, especially with the business plan.
We believe in transparency and the power of giving. From the ELEVATE podcast to this blog and other investor communications (see our post about investor communications), we are constantly thinking about how we can give back to our partners. We truly believe that “the secret to living is giving.”
We believe in the power of a cross-discipline approach. One immediate example of this is Tyler’s application of how both in real-life and in real estate investing, good habits, a positive mentality, and an attitude of constant improvement/growth can lead to exceptional results.

As some of you can relate to previous experiences, these (above) are not characteristics widely found in both the broad and real estate investment world. But to paraphrase the beginning portion of this discussion, “we find comfort in being different.”

As we mature as a team, we are happy to continue to forge our own path, even if this path is often lonelier. Over the long run, we cannot simply follow that which is popular, and expect to do something exceptional as a firm. We are enormously grateful to our partners and audience for their trust in us, the “contrarian guys.”

“Push your boundaries beyond the ordinary; be that “extra” in “extraordinary.”

― Roy T. Bennett, The Light in the Heart

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