American Trust Corporation

Are CAP Rates Still a Valid Indicator of Value?
by John Gregory

Twice a year I have an opportunity to meet with other well-established real estate brokers and property managers to discuss the future of real estate investments. This time we discussed Capitalization Rates (CAP).

What is the CAP Rate? The capitalization rate (or CAP rate) for a property is determined by dividing the property's net operating income by its purchase price.

The CAP rate is used in addition to the cash-on-cash return by many investors to compare their investments to other similar real estate investments. It is used as an indicator because the numbers employed are pre-debt service.

They are also an indication of supply and demand.

As many of you know, CAP rates tend to be linked fairly closely to bank offered interest rates. This means as interest rates lower, CAP rates also drop. High CAP rates may also be an indication of higher risk. In other words a higher return equals less risk, and less risk can equal a lower sales price.

An Overview of the Market Place
Since the high-tech (dot.com) implosion of the stock market, many investors have moved their funds out of stocks and bonds and into real estate. This has occurred at all levels of the market, from individual investors to corporate pension plans. In addition Rich Dad, Poor Dad by Robert T. Kiyosake hit the market. Originally self-published in 1997, it was re-released in 2000 by Warner Brothers Books and had a big impact on baby-boomer investors.

Kiyosake's timing was impeccable. As the stock market cratered, he rode a huge wave on the New York Times best seller list. At the same time Federal Funds rates were adjusted downward by the Federal Reserve (starting in Jan of 2001.) These downward adjustments ended in June of 2004. Both factors fanned the fire in real estate investing.

In sunbelt states where the population is growing exponentially, real estate values have skyrocketed. The U.S. Census Bureau has released new population projections for the next quarter-century, and the political implications are interesting, though not surprising. The following list shows the 10 states that are expected to have the highest population by 2030 along with the 2000 population rank given to those specific states.

States in Order of Expected Population in 2030 (rank as of 2000)

California (1)

Texas (2)

Florida (4)

New York (3)

Illinois (5)

Pennsylvania (6)

North Carolina (11)

Georgia (10)

Ohio (7)

Arizona (20)

Population growth has increased the cost of housing and the pressure on investment property.

On the West Coast, California investors have driven the price of investments to levels never before seen. California CAP rates are hovering between 4 percent and 7 percent, even with no or low increases in rent. Investors are betting on appreciation gains. Those investors that have invested in the 10 fastest growing states have been able to take advantage of some of the upside.

In Portland, Oregon, apartment CAP rates have dropped from 8.3 percent to 7.1 percenet for apartment properties. (Courtesy of the Metro Multifamily housing association Spring 2005 apartment report.) Population growth has created short term shortages of inventory, and builders are furiously building houses and apartments, as well as commercial buildings. Apartment complexes are fetching very high prices because many investors are converting them to condominiums and then selling them as individual units. Those condo developers need to pay close attention to construction defect litigation issues (as discussed in a previous newsletter).

The most interesting revelation at the meeting, however, came from our Los Angeles friend who said that in his area financial institutions were financing properties at pro-forma (or future budgeted rents). Investors are buying properties running with a negative cash flow, paying the monthly cash needs to cover the negative, and then flipping the properties 3-4 years later with up to a 30 percent return in investment.

This sets all investment principles on their head. If this trend continues, investors in California will continue ignoring CAP rate levels, and those in the surrounding states will shift away from a cash flow return model to an appreciation return model.

This will continue until the supply exceeds demand when the market will correct.

The real question is how long that will take. Pundits like Sam Zell think that this pattern might last up to 9 years: "The wealth of liquidity in the real estate market means assumptions have to be rethought," he said, adding that real estate prices would stay high and CAP rates, which are the estimated rate of return on a property at the time of the purchase, would stay low for another nine years "rather than 90 days."

On the other hand, Mr. Anthony Downs, a senior Fellow at the Brookings Institution, was quoted in the same article as saying the real estate market is vulnerable to high interest rate fluctuations and better performance of the stock market, which could pull investors away from real estate as an investment.

In either case, the next 12 months look like low CAP rate transaction months. The future will be driven by the strength of the economy in the fastest growing states.

Even in Spokane, Washington real estate brokers are advertising for listings they can sell to "California investors."

Our conservative group, however, still wants to make sure that there is cash flow to cover the expenses for real estate investments. Why, you ask? Because real estate is unpredictable and does not always appreciate. I therefore encourage you to be thoughtful when you purchase investment property and not let market hysteria drive you to a purchase you might regret.

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Are Cap Rates Still a Valid Indicator of Value?

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	Are CAP Rates Still a Valid Indicator of Value? by John Gregory Twice a year I have an opportunity to meet with other well-established real estate brokers and property managers to discuss the future of real estate investments. This time we discussed Capitalization Rates (CAP). What is the CAP Rate? The capitalization rate (or CAP rate) for a property is determined by dividing the property's net operating income by its purchase price. The CAP rate is used in addition to the cash-on-cash return by many investors to compare their investments to other similar real estate investments. It is used as an indicator because the numbers employed are pre-debt service. They are also an indication of supply and demand. As many of you know, CAP rates tend to be linked fairly closely to bank offered interest rates. This means as interest rates lower, CAP rates also drop. High CAP rates may also be an indication of higher risk. In other words a higher return equals less risk, and less risk can equal a lower sales price. An Overview of the Market Place Since the high-tech (dot.com) implosion of the stock market, many investors have moved their funds out of stocks and bonds and into real estate. This has occurred at all levels of the market, from individual investors to corporate pension plans. In addition Rich Dad, Poor Dad by Robert T. Kiyosake hit the market. Originally self-published in 1997, it was re-released in 2000 by Warner Brothers Books and had a big impact on baby-boomer investors. Kiyosake's timing was impeccable. As the stock market cratered, he rode a huge wave on the New York Times best seller list. At the same time Federal Funds rates were adjusted downward by the Federal Reserve (starting in Jan of 2001.) These downward adjustments ended in June of 2004. Both factors fanned the fire in real estate investing. In sunbelt states where the population is growing exponentially, real estate values have skyrocketed. The U.S. Census Bureau has released new population projections for the next quarter-century, and the political implications are interesting, though not surprising. The following list shows the 10 states that are expected to have the highest population by 2030 along with the 2000 population rank given to those specific states. States in Order of Expected Population in 2030 (rank as of 2000) California (1) Texas (2) Florida (4) New York (3) Illinois (5) Pennsylvania (6) North Carolina (11) Georgia (10) Ohio (7) Arizona (20) Population growth has increased the cost of housing and the pressure on investment property. On the West Coast, California investors have driven the price of investments to levels never before seen. California CAP rates are hovering between 4 percent and 7 percent, even with no or low increases in rent. Investors are betting on appreciation gains. Those investors that have invested in the 10 fastest growing states have been able to take advantage of some of the upside. In Portland, Oregon, apartment CAP rates have dropped from 8.3 percent to 7.1 percenet for apartment properties. (Courtesy of the Metro Multifamily housing association Spring 2005 apartment report.) Population growth has created short term shortages of inventory, and builders are furiously building houses and apartments, as well as commercial buildings. Apartment complexes are fetching very high prices because many investors are converting them to condominiums and then selling them as individual units. Those condo developers need to pay close attention to construction defect litigation issues (as discussed in a previous newsletter). The most interesting revelation at the meeting, however, came from our Los Angeles friend who said that in his area financial institutions were financing properties at pro-forma (or future budgeted rents). Investors are buying properties running with a negative cash flow, paying the monthly cash needs to cover the negative, and then flipping the properties 3-4 years later with up to a 30 percent return in investment. This sets all investment principles on their head. If this trend continues, investors in California will continue ignoring CAP rate levels, and those in the surrounding states will shift away from a cash flow return model to an appreciation return model. This will continue until the supply exceeds demand when the market will correct. The real question is how long that will take. Pundits like Sam Zell think that this pattern might last up to 9 years: "The wealth of liquidity in the real estate market means assumptions have to be rethought," he said, adding that real estate prices would stay high and CAP rates, which are the estimated rate of return on a property at the time of the purchase, would stay low for another nine years "rather than 90 days." On the other hand, Mr. Anthony Downs, a senior Fellow at the Brookings Institution, was quoted in the same article as saying the real estate market is vulnerable to high interest rate fluctuations and better performance of the stock market, which could pull investors away from real estate as an investment. In either case, the next 12 months look like low CAP rate transaction months. The future will be driven by the strength of the economy in the fastest growing states. Even in Spokane, Washington real estate brokers are advertising for listings they can sell to "California investors." Our conservative group, however, still wants to make sure that there is cash flow to cover the expenses for real estate investments. Why, you ask? Because real estate is unpredictable and does not always appreciate. I therefore encourage you to be thoughtful when you purchase investment property and not let market hysteria drive you to a purchase you might regret.	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