Not All Cap Rates Are Created Equal: The Dangers of Hot Markets

Posted May 1, 2024 10:13:52 AM


At Archer, we're fascinated – some might say obsessed – with improving and automates the CRE analysis process. One trend that caught our eye during the recent boom is the tendency to project abnormally high rental growth rates far into the future while assuming operating expenses stay flat. This practice is fraught with risk, especially in markets experiencing a surge in popularity.

It reminds me of the concept discussed in "Soccernomics: Why European Men and American Women Win and Billionaire Owners Are Destined to Lose" where teams tend to overpay for players based on recent success in world cups or their country of origin (cough cough, Brazil), without considering the cyclical nature of performance.

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We've seeing something similar in CRE – investors lured by the immediate returns in hot markets often fail to fully account for the long-term dynamics that can erode those initial cap rates.

The Perils of Extrapolating Growth

Here's a common scenario: Investors flock to a Sunbelt (Texas + Southeast) or Sunshine (Florida) market, drawn by recent explosion of double-digit rent growth. They underwrite deals assuming this growth will persist. However, what they might overlook are these cascading effects:

  • Increased Competition: The influx of capital drives up property prices, pushing going-in cap rates down.
  • New Supply: Developers rush to meet demand, potentially leading to oversupply and downward pressure on rents.
  • Rising Expenses: Appraised values soar, leading to higher property taxes and insurance costs – eating into those projected returns.

The Sunbelt & Sunshine Reality Check

The Sunbelt boom-and-bust is a cautionary tale. Investors drawn by short-term gains are now facing harsh realities:

  • Diminishing Returns: Cap rates are compressing as competition intensifies driving down the final returns compared to the proforma.
  • Unpredictable Tax & Insurance Burdens: Some states lack supply constraints, leading to volatile property tax increases that can decimate NOI.

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The Archer Advantage: Seeing Beyond the Hype

Smart investing requires looking beyond the surface-level numbers. Archer's platform empowers you to:

  • Model Multiple Scenarios: Test different assumptions about rental growth, expenses, and future cap rates to understand the range of potential outcomes.
  • Factor in Market Dynamics: Integrate comprehensive supply and demand data to assess the true competitive landscape.
  • Make Data-Driven Decisions: Base your investment strategies on sound analysis, not just market hype.

Final ThoughtTiming is Everything

As the Simon Kuper, Soccernomics author, noted, "With every player, there is a moment when his value is higher than the price. The key is to get that timing right." The same holds true for CRE investments.

Don't get caught chasing unsustainable growth projections. Let Archer be your guide for navigating the complexities of cap rates and finding the truly valuable opportunities in any market.

Tags: Real Estate Financial Analysis