Cap Rates in Traverse City
Looing at a Cap Rate is similar to looking at the yield on a treasury bond. Simply put, a Cap Rate is the percent return on your money, if you buy real estate and pay with cash. It is an easy way to compare one property’s return to another without doing a lot of math. To determine a Cap Rate, you take the Net Operating Income and divide it by the Purchase Price. If you have a property that makes $80,000/year and the purchase price is $1,000,000, the Cap Rate would be 8% ($80,000/$1,000,000=.08).
Cap Rates change over time and have been falling for the past six years. This is not surprising since interest rates have also been falling and investors are in search of assets with higher yields. The increased demand for real estate means more competition, higher prices, and lower returns. Logic would tell us that Cap Rates should begin to rise when the fed begins to raise interest rates. While this is certainly a factor, the rates are also influenced by a number of other factors such as supply and demand for space. When demand outstrips the supply of available spaces, Cap Rates are pushed lower. The risk of inflation will also put downward pressure on Cap Rates since investors view real estate as a hedge against inflation (rents will rise if there is inflation). Another important factor is the availability of money to borrow to buy a property. If it is easily available, such as the current situation, it will put downward pressure on Cap Rates. A few years ago that was not the case.
Cap rates are dropping even in Traverse City. In areas where demand is extremely high, such as downtown, we are seeing properties sell for record highs with Cap Rates as low as 4-5%. Just a few years ago these properties were selling for close to 8% Cap Rates. In areas where demand is not as strong, but as little as 2 miles away, we are seeing properties sell for 8-9% Cap Rates. Again, this is down from a few years ago. Demand has been so high lately, that there are only a handful of investment properties available on the market. Traverse City is one of the up and coming areas around the state, and many investors are looking to buy investment properties here, assuming that values and income will increase as the area continues to grow.
There are many ways to evaluate the return on an investment and Cap Rates are just one. They can be very useful, but the buyer needs to be aware that the Cap Rate they are given by a seller is accurate. Often the income stated does not include all of the expenses or an accurate vacancy rate. If a building is nearing a time when it will need capital improvements, these costs should be factored in as well. There may be a lease that is higher than market rate, or is expiring soon and a tenant will need to be replaced. It is important to understand all of these factors before deciding if a building is a good value based on the Cap Rate. However with a good advisor and accurate financials, Cap Rates are a good investment analysis tool and worth using when deciding where to invest your money.
-Dan Stiebel, CCIM