This was a question we received from one of our investors recently. With the rapid rise in interest rates, investors are naturally concerned about the impact on Cap Rates and asset valuation.
To address this concern, here is a reminder that the Cap Rate is not just a function of interest rate but many other factors.
- Asset valuation is a function of both the Cap Rate and Net Operating Income (NOI).
- At this point, the fundamentals of Supply and Demand of rental units may be playing a bigger role than the interest rate. And the very high inflation levels are complicating things further.
The Net Operating Income (NOI): Rental income is still rising faster than expenses, thanks to historically high demand for rentals and the supply hasn’t kept up with the strong demand. This has allowed continued growth of NOI, with other things remaining constant. Reports of double-digit annual rent growth have made headlines in the last year and more and continue to hold strong.
Supply and Demand of rental units: Specifically for certain types of assets, there is a continued shortage of supply of new rental units. The supply shortage is likely to continue as construction costs have risen and supply chain issues continue to persist. Newer Class A units that have come to the market are simply not affordable. The rising interest rate environment has also kept the demand for rentals high as high mortgage costs have weakened the case for home ownership.
We also believe that the recent inflation will continue to make real estate more valuable. The replacement cost has also increased significantly and might come down slightly but we believe there has been a permanent upward shift.
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