01/12/2009 01:47 pm ET Updated May 25, 2011

Cap Rate Decompression

It seems like just a year ago I was speaking with a buddy of mine who specialized in investment sales of large real estate properties. As I was performing due diligence on some of these properties for an acquisition group I represented, I was very familiar with the numbers. When I heard the seller's asking price, and subsequently was stunned by the sales price, I asked (demanded?) my buddy for an explanation.

"Jim, you just don't get it ... it's cap rate compression."

Let me back up a bit for those who are not familiar with "cap" rates. The cap rate, short for capitalization rate, is the return that a real estate investor will accept on an unleveraged purchase (no debt). Since 90% of investors use debt to make an acquisition, the cap rate is just a measure - a scoring system of sorts.

By way of example, if an office building is in a top location with lots of room for potential rent increases, a buyer will presumably accept a lower rate of return on his cash than would a buyer of a similar building in a B location with less upside. In other words, the buyer of the primo building will purchase with a lower cap rate. In order to determine purchase price, the net operating income of a building is divided by the cap rate. So, a building yielding an NOI of $100,000 is worth $2,000,000 to the 5% cap rate buyer but only $1,666,666 to the 6% cap rate buyer.

What was driving me nuts was that the cap rates that buyers would accept kept dropping, meaning, more importantly for my purposes, buyers would pay more money than made sense to me. When my buddy told me that higher prices were the result of a cap rate compression, what he was really saying was that the investment community saw investment real estate as a low-risk, high-reward asset class - to be purchased with less immediate return given its obvious upside potential.

Unfortunately, since about a year ago, the cap rate compression has turned into a cap rate decompression. Now, investment real estate is not viewed with the same rose-colored glasses that it was just a year ago. Instead of cap rates going down, they are going up, meaning that the typical investor will pay less for a property than he would have only one year ago.

What is happening is part of the de-leveraging of America's assets. Instead of lenders seeing the stability of asset classes like real estate, they are seeing only the risks. As a result they want more equity to secure loans. They want higher interest rates, more escrows and reserves and more stringent underwriting.

Between the de-leveraging and the cap rate de-compressing, most experts predict that we are in for a very tough 2009 when it comes to investment real estate.

Jim Randel is the author of the just-released book, The Skinny on The Housing Crisis (Clover Leaf, 2008).