The trend of capitalization rate (cap rate) expansion that started in 2023 and continued through the year was initially anticipated to continue in the short term for most real estate asset classes. However, now the predictions are ‘higher for longer’, which means it will continue to rise in 2024. Recent data indicates that cap rates have increased by an average of 50 basis points across major markets in the past year.
This has been influenced by factors like economic uncertainties, inflationary pressures, currency fluctuations, and changes in investor preferences. The impact of this expansion is significant because it inversely impacts the value of properties.
Let’s break it down!
Before we delve into expansion, let's establish the baseline. A cap rate is a metric used to estimate a property's potential return on investment at the point of acquisition. It's calculated by dividing the property's net operating income (NOI) by its current market value. It basically indicates the minimum rate of return that is expected to be generated on a real estate investment property. Simply put, a higher cap rate suggests a higher expected return.
The impact of this cap rate expansion is multifaceted. On the one hand, it presents opportunities for investors seeking higher yields, especially in secondary and tertiary markets where cap rates have seen a more significant uptick. On the other hand, it signals caution for property owners and developers, as higher cap rates can lead to downward pressure on asset values and potential challenges in securing favorable financing terms.
Interest Rates vs Cap Rates – The dynamics
Falling interest rates are expected to have a direct impact on commercial property cap rates (which is similar to the inverse of what PE is for stocks). The impact of cap rate expansion varies across different asset classes. When interest rates decrease, cap rates can decrease and decreasing cap rates increase a property’s value as cap rates and commercial property prices are inversely related.
With RBI eyeing more rate cuts, cap rates are also expected to decrease resulting in a price boom for commercial and retail properties. Prudent investors may consider buying now to take advantage of the expected fall in cap rates.
If we look at the Grade A office market in APAC, the average cap rate in India is around 7-8 while Japan, Singapore, South Korea are between 3 and 4, and the Middle East market is at around 6 (December 2023). This has led to a decrease in overall market values in many regions.
What’s the future looking like?
Cap rates for prime assets will gradually start falling in H2. For secondary assets and tier two markets, the cap rate compression may take little longer, where investors are looking for older assets that need to be refurbished or redeveloped to bring them in line with new ESG and other regulations. In terms of investment, we will continue to witness more Asian investors (Singapore, Japan, Hongkong, South Korea etc.) getting attracted to India’s economic growth, government policies, growing consumer market and opportunities in technology and other emerging sectors.
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