Capitalization (cap) rates usually move in tandem with short-term rates. But the picture is more nuanced, as evidenced by the mixed action in cap rates seen over the past year.

First, some background information on cap rates in California.

Data-driven real estate investors identify a property’s investment potential by first looking at its cap rate. The cap rate is calculated by dividing the net operating income (NOI) by the property’s price. For buyers of real estate, the higher the cap rate the better, as a higher cap rate translates to a lower purchase price and a greater yield.

Each property’s cap rate measures the annual rate of return produced by the operations of the income property. This is stated as a percentage of invested capital.

More specifically for rental properties, the cap rate is presented as the annual yield — the continuing receipt of net operating income calculated for each year of ownership — from rental operations as compared to the seller’s asking price.

Low cap rates become acceptable to cash-heavy investors faced with few other investment opportunities (think: San Francisco and San Jose). In California, higher cap rates tend to be found in inland areas where inventory is greater and competition is less severe.

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The relationship between cap rates and interest rates

Recent years have seen investors become increasingly interested in the profit they can receive from buying and selling. This occurs when prices increase rapidly, as they have over the past three-to-four years. Therefore, low cap rates have become increasingly acceptable to investors uninterested in the income produced by the property’s operations from year-to-year.

However, interest rates over the past 20-30 years have seen an overall decline, a trend which is now reversing. This will produce a sea change for real estate investors, who will now need to place a greater importance on cap rates.

The Federal Reserve (the Fed) has increased the short-term interest rate several times since the end of 2015. Since the Fed began juicing the short-term rate, it has increased from essentially zero in December 2015 to 1.16% in August 2017, according to the Federal Reserve Bank of St. Louis.

Interest rates move in long-term cycles. Over the past century, the trend for interest rates is 20-30 years of rising rates, followed by 20-30 years of falling rates. In 2017, we are just beginning to rise from the bottom of the cycle, which bottomed in 2012. Therefore, the trend for the next two-to-three decades will be rising interest rates. This is the new epoch, so get used to it. This new paradigm of rising rates will put downward pressure on real estate prices as borrowers will have to pay more to have access to mortgage financing.

Investors know of the relationship between interest rates and prices. Thus, they know that in future years they will have to rely more on income produced by the operations of a property, rather than the profit from buying and selling in anticipation of market momentum.

Therefore, you often see a positive correlation between Fed rate action and cap rates. When the Fed moves the short-term rate up, this signals the need for higher cap rates. Thus, prudent investors act accordingly to safeguard their future yields.

Today’s cap rates

Apartment cap rates have actually decreased since the Fed began amping up their increase of the short-term rate at the end of 2016, as reported by REIS.

REIS suggests the reason for lowered cap rates among apartments may be the comparative safety that apartment properties historically offer investors. The extremely low apartment vacancy rates, coupled with little new multi-family construction, means low cap rates continue to be acceptable for apartments.

Likewise, retail cap rates have actually increased very slightly over the past year. REIS points to the strong rents the retail sector continues to demand.

However, office cap rates have risen slightly over the past year, reflecting the rise in the short-term rate as well as investor uncertainty in this sector.

While today’s cap rates are mixed, long-term investors need to consider higher cap rates going forward in the 20-30 year period of steadily rising interest rates. As interest rates continue to rise, price increases will slow and higher cap rates will be needed to ensure a positive yield. Without a high cap rate, mortgaged property owners will be unable to cover even needed maintenance and updates to remain competitive in the future.

Agents can help by educating their investor clients — especially those who are relatively new to property investment — on the importance of cap rates.

To read more on cap rates, see: Capitalization rates, explained.