Cap Rate Compression

Cap Rate Compression refers to a scenario where capitalization rates (cap rates) decrease over a period of time. This can occur in a real estate market when property prices increase faster than the net operating income (NOI) of those properties.

The cap rate is calculated by dividing the NOI of a property by its market value. When property values increase while NOI stays the same or doesn't increase as much, the cap rate decreases – this is known as cap rate compression.

Cap rate compression often occurs in a competitive or "hot" real estate market, where demand for properties is high and investors are willing to pay higher prices for properties. This might be due to low interest rates, economic growth, or a lack of alternative investment opportunities.

While cap rate compression can lead to higher property values (which may benefit property sellers or those looking to refinance), it also means that new investors are getting a lower initial return on their investment, as they are paying more for the same amount of income.

It's important to note that the opposite scenario – where cap rates increase because property prices are falling or NOI is rising faster than property values – is known as cap rate expansion. This can occur in a less competitive market, where demand for properties is lower.

As always, investors should look at a range of factors and not rely solely on cap rates when making investment decisions.