Understanding Cap Rates and their role in §1031s & DSTs~ Part 2

In Part 1, we did an overview of under­stand­ing cap rates in their roles in 1031 exchanges as well as Delaware statu­to­ry trusts. In this part, we will dive a lit­tle deep­er into the effects of cap rates over the peri­od of own­er­ship and how it may affect the exit or dis­po­si­tion of the real estate. Click this link to see Part 1. Under­stand­ing Cap Rates Part 1

March 27, 2025

By Al DiNi­co­la, AIF®
1031 Tax Deferred Exchange Spe­cial­ist & DST Advisor/Specialist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC

There are sev­er­al items and issues that may affect the invest­ment. The net oper­at­ing income or NOI of the prop­er­ty dur­ing the term of own­er­ship may fluc­tu­ate. Indi­vid­ual investors sim­ply take the rent rolls or rental income the pre­vi­ous own­er of the prop­er­ty had and used that as a basis for pro­ject­ing income over their own­er­ship of the prop­er­ty. Spon­sors of Delaware Statu­to­ry Trust, or DST will uti­lize a process that includes pro­jec­tions or pro­for­mas as they are known when devel­op­ing a new prop­er­ty. For exam­ple, if a spon­sor is acquir­ing a brand-new apart­ment com­plex, they will typ­i­cal­ly project a peri­od on how long it will take to lease up the prop­er­ty. This pro­ject­ed “lease up” peri­od may be any­where from 18 to 24 months or longer. Dur­ing that lease up the oper­at­ing income will increase as more and more units are rent­ed by indi­vid­ual ten­ants. Indi­vid­ual investors that buy exist­ing rental prop­er­ties or invest­ment prop­er­ties will hope­ful­ly expe­ri­ence renewals of leas­es to main­tain their net oper­at­ing income. Over the years many investors as well as spon­sors have pro­ject­ed a spread between an increase in oper­at­ing expens­es and rent increas­es. An exam­ple may be oper­at­ing expens­es increas­ing 3% per year and rent increas­es 5% per year.

There are items that will affect this net oper­at­ing income, specif­i­cal­ly expens­es. Oper­at­ing expens­es may expand or con­tract that will direct­ly affect the “net” oper­at­ing income. When an indi­vid­ual investor pur­chas­es a prop­er­ty, the local munic­i­pal­i­ty may reeval­u­ate the val­ue of that prop­er­ty and increase the val­ue which will have a direct effect on tax­es due on that prop­er­ty. There have been sev­er­al inci­dents where we have heard from investors whose prop­er­ty tax­es have increased over a one-to-two-year peri­od of own­ing the prop­er­ty. On the res­i­den­tial side, we have had investors in Flori­da who have pur­chased the prop­er­ty from a sell­er who owned the prop­er­ty as their pri­ma­ry res­i­dence. In Flori­da res­i­dents enjoy a des­ig­na­tion called home­stead exemp­tion. That home­stead exemp­tion lim­its the amount of increased val­u­a­tion year over year to 3%. This direct­ly affects prop­er­ty tax­es.  When a new investor pur­chas­es the prop­er­ty, the val­u­a­tion could increase dras­ti­cal­ly. Espe­cial­ly if the new investor is pur­chas­ing it as a rental prop­er­ty. The val­u­a­tion of the prop­er­ty may be based on the sales price that the new investor has paid. The prop­er­ty as a home­stead may have enjoyed years of only a 3% increase. We have seen the val­u­a­tion dou­ble. There could be a 50% year-over-year increase in tax­es. Many times, new investors do not antic­i­pate this recal­cu­la­tion of the val­ue of the prop­er­ty that’s being pur­chased.

Typ­i­cal­ly, spon­sors will project increas­es in prop­er­ty val­u­a­tions, espe­cial­ly in the case of a new­ly built mul­ti­fam­i­ly apart­ment com­plex. How­ev­er, there have been munic­i­pal­i­ties in sev­er­al states that have increased val­u­a­tions (above nor­mal pro­jec­tions), which will have a direct impact on increased tax­es. There are sev­er­al peti­tions cur­rent­ly chal­leng­ing the increased val­u­a­tions.

Cur­rent Stress on Assets

There are a few asset class­es includ­ing mul­ti­fam­i­ly that are expe­ri­enc­ing (what some experts sug­gest is tem­po­rary) is cap rate expan­sion.  The rise in inter­est rates over the past few years as well as the num­ber of new mul­ti­fam­i­ly apart­ments being built and deliv­ered is putting stress on ca rates.  The rise in oper­at­ing expens­es (tax­es & insur­ance) and the flat rental increas­es are caus­ing the stress.  The good news on the sup­ply pipeline is that by mid-2025 there appears to be a dra­mat­ic reduc­tion in future sup­ply.

Cap Rate Com­pres­sion vs. Expan­sion

• Cap Rate Com­pres­sion: Occurs when prop­er­ty val­ues increase while NOI remains sta­ble, reduc­ing the cap rate. This often hap­pens in low-inter­est-rate envi­ron­ments or when investor demand is high.
• Cap Rate Expan­sion: Hap­pens when prop­er­ty val­ues decrease or NOI declines, lead­ing to a high­er cap rate. Ris­ing inter­est rates, eco­nom­ic down­turns, or over­sup­ply of prop­er­ties can dri­ve expan­sion.
• Remem­ber- low­er cap rate may increase val­ue or price.  There is an inverse rela­tion­ship.

The Role of Cap Rates in §1031 Exchanges

A §1031 exchange allows investors to defer cap­i­tal gains tax­es by rein­vest­ing pro­ceeds from a sold prop­er­ty into a “like-kind” replace­ment prop­er­ty. Cap rates are cru­cial in eval­u­at­ing replace­ment prop­er­ties with­in the §1031 exchange process.

Cur­rent Mar­ket Trends & §1031 Exchanges

1.           Ris­ing Inter­est Rates & Cap Rate Expan­sion

• With the Fed­er­al Reserve tight­en­ing mon­e­tary pol­i­cy, bor­row­ing costs have increased, lead­ing to cap rate expan­sion across many asset class­es. Investors sell­ing prop­er­ties pur­chased dur­ing a low-rate envi­ron­ment may face low­er val­u­a­tions on their replace­ments.

2.           Shift in Investor Demand

• While demand remains strong for high-qual­i­ty assets like indus­tri­al and mul­ti­fam­i­ly prop­er­ties, cer­tain sec­tors, such as office and retail, have seen cap rate expan­sion due to uncer­tain­ty and struc­tur­al shifts in demand.

3.           DSTs as a Poten­tial Solu­tion in a Volatile Mar­ket

• Delaware Statu­to­ry Trusts (DSTs) pro­vide an alter­na­tive invest­ment option for §1031 exchange investors look­ing for diver­si­fi­ca­tion and sta­bil­i­ty in uncer­tain times. DSTs offer frac­tion­al own­er­ship in insti­tu­tion­al-qual­i­ty real estate, man­aged by pro­fes­sion­al spon­sors.

In a ris­ing inter­est rate envi­ron­ment, investors may find it chal­leng­ing to locate suit­able replace­ment prop­er­ties with favor­able cap rates. DSTs allow investors to access pre-vet­ted prop­er­ties with sta­bi­lized returns, reduc­ing the risk of fail­ing to com­plete a §1031 exchange with­in IRS time­lines.

DSTs also offer a pas­sive invest­ment struc­ture, remov­ing the bur­den of active man­age­ment, which can be appeal­ing in an unpre­dictable real estate mar­ket.

How­ev­er, investors should care­ful­ly eval­u­ate each DST offer­ing, includ­ing spon­sor expe­ri­ence, under­ly­ing prop­er­ty per­for­mance, and poten­tial risks. DST invest­ments are sub­ject to spe­cif­ic risks and may not be suit­able for all investors. Con­sult­ing a finan­cial pro­fes­sion­al is rec­om­mend­ed before mak­ing invest­ment deci­sions.

Key Con­sid­er­a­tions for §1031 Exchange Investors

• Mon­i­tor Cap Rate Trends: Under­stand­ing whether cap rates are com­press­ing or expand­ing can impact prop­er­ty val­u­a­tions and invest­ment deci­sions.
• Eval­u­ate NOI Growth: Prop­er­ties with strong NOI growth poten­tial may off­set cap rate expan­sion con­cerns.
• Con­sid­er DSTs for Diver­si­fi­ca­tion: DSTs can pro­vide access to insti­tu­tion­al-qual­i­ty real estate and pas­sive income poten­tial.
• Act Quick­ly in a Volatile Mar­ket: With shift­ing cap rates, §1031 exchange investors must be proac­tive in iden­ti­fy­ing replace­ment prop­er­ties with­in IRS time­lines.
• Con­sult a Finan­cial Pro­fes­sion­al: DSTs and oth­er §1031 exchange options should be con­sid­ered based on indi­vid­ual invest­ment objec­tives, risk tol­er­ance, and finan­cial goals.

NAMCOA® is a SEC reg­is­tered invest­ment advi­so­ry firm that pro­vides com­pre­hen­sive port­fo­lio man­age­ment, finan­cial plan­ning, and fidu­cia­ry deci­sion-mak­ing ser­vices on behalf of retire­ment plan spon­sors. Our Dif­fer­ence is sum­ma­rized by our fidu­cia­ry approach which enables us to bet­ter meet port­fo­lio and retire­ment plan objec­tives, result­ing in stronger risk adjust­ed returns for investors and peace of mind for Clients. We also focus on alter­na­tive real estate invest­ment. Many real estate investors are seek­ing tax deferred solu­tions uti­liz­ing §1031 exchanges or Oppor­tu­ni­ty Zones.

DSTs are not for all investors.  The acqui­si­tion of a DST is for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your §1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC §1031 Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 5 Cen­ter­pointe Dri­ve, Ste. 400 Lake Oswego, OR, 97035. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.