Cap Rates Below Inflation - Implications?

In recent memory, cap rates have typically been above the overall inflation rate. What I'm trying to wrap my mind around is how conceptually should I be viewing the relationship between cap rates / inflation, but specifically in an environment where cap rates are BELOW inflation. Meaning that on a 6-cap you'd actually be losing money if you can't grow NOI such that the cap rate keeps up with the > 6% inflation rate. Wouldn't you be better putting your money in I-Tbonds or equities markets or something that at least offers an upfront return greater than inflation? This question should be viewed in the context of core stabilized yield-driven investing and not something that requires a ton of risk (slight value-add through operational efficiencies at most, i.e. no redevelopment). 

I feel like I'm missing something crucial in how I should be thinking about it.

I say this from someone who just exited their first RE investment (slam dunk), but I did it right before rates started rising. I'd really appreciate any guidance from more experienced folks who have seen a couple cycles and different financing environments.  Thanks.

Comments (6)

Jun 29, 2022 - 11:16pm
Steam, what's your opinion? Comment below:

EBITDAX_addbacks

In recent memory, cap rates have typically been above the overall inflation rate. What I'm trying to wrap my mind around is how conceptually should I be viewing the relationship between cap rates / inflation, but specifically in an environment where cap rates are BELOW inflation. Meaning that on a 6-cap you'd actually be losing money if you can't grow NOI such that the cap rate keeps up with the > 6% inflation rate. Wouldn't you be better putting your money in I-Tbonds or equities markets or something that at least offers an upfront return greater than inflation? This question should be viewed in the context of core stabilized yield-driven investing and not something that requires a ton of risk (slight value-add through operational efficiencies at most, i.e. no redevelopment). 

I feel like I'm missing something crucial in how I should be thinking about it.

I say this from someone who just exited their first RE investment (slam dunk), but I did it right before rates started rising. I'd really appreciate any guidance from more experienced folks who have seen a couple cycles and different financing environments.  Thanks.

Nobody assumes 6% inflation will continue into perpetuity. Cap rates are somewhat connected but not directly connected to inflation. Inflation varies YoY but over the long term should average out to 2-3%. Cap rates are just a function of what you bought a single years returns at, they have no bearing on ongoing inflation - that's up to you to decide as landlord how you react going forward.

If you buy an asset Y0 at 4% cap but inflation that year hits 6%, what impact does that even have on your investment? Ideally you should be somewhat engineering opex to perform better next year and grow higher wherein inflation is not 6% the next year…you will eventually catch up if you know how to operate buildings, if not, you will lose the asset.

A single years inflation is not going to change cap rates.

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Jun 30, 2022 - 2:11pm
bolo up, what's your opinion? Comment below:

Makes me think of the Yogi Berra quote haha: In theory, theory and practice are the same. In practice, they are not.

But yes, good point. In addition to interest rates - part of the reason why long-term NNN deals are so negatively impacted by inflation - growth is already baked so you need to make up for in cap rate to get same return. Shorter-term leases (residential, hotels, etc) should allow LLs to track inflation more closely - but always going to be dependent on micro market supply/demand dynamics, regulation, other economic conditions (will luxury hotel room rates continue to rise in stagflationary environment?) Etc…

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Jun 30, 2022 - 9:54am
Trunk Yeti, what's your opinion? Comment below:

Take a look at the link below.  Crow Holdings Director of Research just released a white paper discussing this exact issue in detail.  I am not nearly as pessimistic as some of my peers.  In my opinion, the FF rate going to 3.50% - 4.00% is already priced into the capital markets / valuations, and most of the price movement has already occurred.  On a 10 year analysis, the speed at which we get to that 3.50% - 4.00% target rate in the next 18 months is mostly irrelevant to the overall math.

We do need the supply side of the economy to fix itself though which is going to take time.  Right now I think a mild recession to cool off demand and let supply catch up would probably benefit the long-term health of the economy.

https://smu.app.box.com/s/bejpudacvmg2ozpdop3hv6hk75j8evz9

Jul 1, 2022 - 12:04pm
Goldmans_Snacks, what's your opinion? Comment below:

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