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Real estate can be a hedge against inflation. But it's not guaranteed.

Cap rates and yield are two very different things.  One is set by market demand, and one is created by smart management.  And yet, a large segment of the real estate investment community believes they are one and the same.Cap rate is the market price to acquire a real estate revenue stream.  It is typically based on the next twelve months of income, hopefully most of which is contractual, and it tends to be aspirational in the short-term, a best-case scenario.  The value an investor creates is the spread between the market price and the actual yield it returns.Yields are both the actual historical return on investment and the detailed projection of a business plan. Because cap rates are a function of the market and as such are outside anyone’s control, a savvy investor must estimate the future revenue and determine if it creates enough value to justify the market's price today.  Over time, you evaluate if the actual yield has sufficiently rewarded you for the initial investment. Mind the GapA good rule of thumb is that the lower the cap rate, the closer it will be to the actual yield, and the higher the cap rate, the more significant the gap.  Lower cap rates imply higher-quality revenue and higher-quality properties.  Therefore, you have fewer vacancies and lower ownership costs.  High cap rates imply just the opposite.  You show me a 12% cap rate, and I will show you a 1970s office building. High cap rates are a great time to add value.  That property will never generate a 12% annual return, but if you can improve the revenue stream to the point that someone will pay a 6% cap for it, you created a tremendous amount of value.  The same is true for low cap rates; if you can generate a 7% yield on a 4% cap rate, you have created value.Achilles HealAll too often, investors and those trying to separate them from their money treat cap rates as if they are as certain as treasury bond yields.  When, in fact, they are a highly subjective indication of investor demand.The belief that there is a correlation between cap rates and treasury yields is a myth born from the fact that real estate debt is largely priced off the ten-year U.S. Treasury.  Some believe that if the ten-year rate is 5%, real estate should trade at some spread above that.  The idea is not wrong; investors are just using the wrong metric.  It is the yield that should trade at a spread over the ten-year.  Cap rates are just a function of demand and supply within the real estate market.  And that is a very different market than the debt market.It seems reasonable, even intuitive, to most that a rising cost of debt should reduce investor demand.  Thus, cap rates should rise, and prices should fall.  But supply is the other side of this seesaw, and pricing stays flat if supply falls with demand, which is precisely what is happening in the opening act of 2024.  Investment demand has fallen, but supply has decreased almost as much.  The inventory for sale is so low right now that cap rates are holding up better than treasuries. Little LiarsCap rates are cunning; they tell you something about the market’s balance of supply and demand.  The balance between the amount of capital chasing deals and the number of qualified investments.  But they are silent on whether or not investors are overpaying.  They tell you nothing about the underlying balance of the supply of properties and tenant demand.When cap rates are low, below what an acceptable return would be, the investor is betting the market will appreciate, either through revenue growth or price appreciation.  An appreciating market should be a good time to invest.  The market will tell you this right up to the point that it changes direction, which can be sudden and severe.After the market lures you in with promises of growth, it scares everyone away when prices start to decline.  The fear that it will decline further, that cap rates will increase more, outweighs the good sense that a lower price today for what you were prepared to buy yesterday is a good thing.  Investors become focused on trying to buy the bottom and miss the chance to buy a good return out of fear for the market’s fluctuations over the short-term.Under the HoodThe only acceptable valuation method for a prospective investment is carefully analyzing all future cash flows against the basis in your investment, which we have defined here as yield.  In order to see through the beguiling song of the cap rate an investor must dig deep into the supply of comparable product within the competing market and develop an opinion about the future of revenues and expenses.  They must attempt to predict the yield the property will generate over time.Most importantly, they must distinguish between physical supply and demand within the market and the supply and demand of investments and capital.  The lie that cap rates are telling you is that they are the same thing. That cap rates represent the physical supply and demand of property and tenants, when in fact they are driven by an entirely different thing, capital.High NoonOver the last decade, many real estate operators and investors haven't added much value.  They did not grow yield or improve the asset.  However, because the capital market demand drove down cap rates, the market increased the spread between price and yield for the investor.  Demand grew aggressively because more and more capital entered the market looking for investments.  After the dramatic interest rate tightening by the Federal Reserve, capital exited the market, and there is no doubt that caused demand to decline.  However, so did the supply of investments, and the market adjusted prices down but not significantly, at least not yet.The capital market sets the price for real estate, and we call that cap rate.  The investor creates value by growing the spread between the yield they are earning on the investment and the cap rate the market is willing to pay for it.  Cap rates can tell you a lot about the market, but yield is the ultimate judge of whether or not you have created value.  Please do not mistake one for the other.  Mr. Market doesn't care about your capital when it sets a price, and it often goes off its meds and behaves erratically.  Yield is the truest measure of return; and it is a painful high noon prairie sun.Sincerely,Powered by beehiiv