Nobody knows for certain where we are in the real estate cycle, but we do know that there has been a strong and prolonged upswing nationwide over the past seven years. From the beginning of 2012 until the end of 2018, home prices appreciated by 50% across the US, with certain markets like Miami, San Francisco, and Detroit more than doubling in value during that time period.

From an investment perspective, these gains can be attributed to two factors

  1. Market rent increases
  2. Cap rate compression

Here’s how the 25 biggest markets by population look like when sorted by these factors:

Some interesting data here.

On average, 57.7% of all the price appreciation was attributable to cap rate compression, while 42.3% was due to increases in market rent.

Detroit and Miami: While Detroit and Miami experienced the greatest home price appreciation over this seven year period, the majority of that can be attributed to cap rate compression. In fact, although Detroit saw some of the highest appreciation, the market rent growth over that timeframe was among the lowest in the sample set.

Denver and Portland: Both of these markets were top 10 performing markets and both had the majority of their growth due to rental growth with a lower than average appreciation due to cap rate compression.

New York and Boston: These markets underperformed national appreciation numbers but had rental growth that was better than the national average. These cities had limited to no appreciation due to cap rate compression.

So, what does this mean and what happens next?

It would be irrational to predict further declines in cap rate in the coming years. Instead, the more conservative assumption is that cap rates return to historical norms.

If we revert cap rates back to their 2012 levels, here’s what happens:

Can this happen? Maybe. Who knows. Would interest rates even need to rise for this to happen? Remember, the 10-Year Treasury yield was below 2% at the end of 2011.

But if you are worried about rising cap rates for whatever reason and are looking to protect capital, the cities toward the bottom of the list provide some security based on this analysis.

Are we surprised that New York is at the bottom of this list? Not at all — New York real estate is a global commodity. Investors from all over the world park capital in New York real estate. In today’s market with all of the uncertainty, it might be a good time to think about capital preservation strategies.

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