Deep Dive Into Cap Rates: Will Cap Rate Expansion Continue in 2024?

Higher Borrowing costs, uncertainty around monetary policy, and continued disconnect between buyers and sellers force cap rates upward.

Cap rate expansion, the scenario in which the capitalization rate of real estate assets collectively rises, began in 2023 and has continued throughout the year. It was initially anticipated that cap rate expansion would continue in the short term for most real estate asset types, peaking in Q4 2023 and slowly decreasing in 2024 as the Fed ends its rate-hike cycle. However, with rates now anticipated to be “higher for longer,” where does this leave cap rate rates? And where are they predicted to fall in 2024?

What is the Cap Rate Expansion?

Cap rate expansion refers to the increase in capitalization rates. Although higher cap rates translate to the possibility of a higher profit, they also suggest assets carry more risk. Buyers expect lower property pricing to offset this risk to improve their odds and ensure higher yields. The decrease in price causes overall market values to drop. As of August 2023, all-property year-over-year price change was -9.9%, according to Real Capital Analytics.

There are some exceptions to the rule where cap rate expansion does not cause a decline in property values. Those often include limited supply, significant demand, or heightened investor activity.

Factors Influencing Cap Rate Expansion

There are a few main drivers for cap rate compression and expansion. Major macroeconomic shifts and market fundamentals are the primary contributors.

Interest Rates

In July, the Fed raised interest rates a quarter point to 5.25%-5.5%, the highest level in 22 years. The Fed paused on a rate hike in September. Although rate increases has helped inflation decrease, it has caused the commercial real estate market to experience higher cap rates. As the cost of borrowing increases, investors require a higher return, and cap rates increase.

Market Dynamics

Suppose a market has excess supply from robust development pipelines or dwindling demand. In that case, sellers are forced to lower their property pricing as the buyers gain leverage in a non-competitive market. In turn, cap rates increase.

Sector Shift

Major changes in consumer trends or global events, such as COVID-19, can cause certain sectors to experience high or low performance for a specific period. During the pandemic, e-commerce exploded, causing industrial storage and warehouses to increase in demand as online retailers needed space. Multifamily cap rates were also affected, as consumers migrated to the suburbs in droves, causing a supply and demand imbalance throughout several secondary markets in the U.S.

How Have Cap Rate Adjusted?

All major product types report increased cap rates as investors struggle to achieve high yields in the current debt environment. Some sectors have softened the expansion more than others, showing strength and resilience.

Retail

Single tenant net lease (STNL) retail has experienced cap rate expansion, but compared to other sectors, the rate of expansion has been much slower. STNL continues to be a desirable asset for buyers as it benefited greatly from the surge in consumer spending because of the COVID-19 related stimulus. Retail tenants’ sales have performed well over the last two years, which has led to expansion and opportunity for landlords to drive up rents. STNL assets with strong real estate fundamentals continue to trade and are less affected by the interest rate environment. Within the private capital retail sector, cap rates have only increased 25-50 basis points in the past 12 months, according to CoStar Group. Outside of private capital, the retail sector has reported an increase of 50-75 basis points. Still, this increase is half the rate of other product types. Pricing has decreased by 11% as of September 2023, per CoStar Group.

Industrial

Industrial saw historical cap rate compression in 2021; however, in 2023, the asset type is experiencing cap rate expansion of 100-150 basis points. RCA reported a 5.7% average cap rate for U.S. industrial in August, with older assets in the 6%+ range and new builds averaging the 5%+ range. This figure was up 50 bps from a year earlier, which was the low point for cap rates in this cycle. Sales volume is down over 50% year-over-year, but all-cash buyers remain active in attractive markets.

Multifamily

While mortgage rates have risen 210 bps from their trough, multifamily cap rates expanded by 40 bps to an average of 5.1% in August 2023. As reported by Real Capital Analytics, annual sales volume is down 76% and year-over-year pricing is at -12.2%. However, cap rates stabilized to only a 1% increase in Q2, suggesting the sector may see the peak towards the end of the year and modest cap rate compression in 2024. Luxury apartments are experiencing the least expansion, trading in the 4%-5% range, whereas older assets are trading in the 5%-6% range. Until the relationship between cap rates and mortgage rates normalizes, deal volume is expected to idle.

2024 Outlook

The rapid increase in interest rates means lower pricing on acquisitions is necessary to achieve healthy returns. However, the pricing gap hasn’t yet fully been realized, resulting in uncertainty that’s keeping buyers on the sidelines.

Cap rates are expected to peak in Q4 2023 but expand at a slower rate until interest rates fall and stabilize in 2024. A price discovery phase will happen in the next quarter to the first half of 2024, narrowing the dislocation between buyers and sellers leading to higher transaction volume. The Fed is also expected to lower interest rates in 2024, helping cap rates decrease and investors to secure debt at a more affordable price. During periods of cap rate expansion, investors will need to outweigh the risk to reward, but there are still plenty of opportunities on the market that provide high yields and stable cash flow.