Question

What is likely to happen to the average CAP rate in the market under each of the following conditions. Briefly explain.

1. Rising interest rate environment.

2. Growing perception that real estate is becoming riskier than previously viewed.

3. Expectations that future inflation will increase

Answer 1

Capitalisation rate (Cap rate) is the rate which indicates the investment return in and real estate assets (properties). It is the percentage of net income that is expected to earn from real estate investmensts.

• Rising interest rate environment - with rise in interest rate, the real estate investors would also want greater return on their investments, and hence average cap rate should increase. In effect, cap rates move 1-for-1 with real interest rates in the long run.
• Growing perception that real estate is becoming riskier than previously viewed - In such a scenario, average cap rate would decrease since investors would try to park thier savings in something less riskier.
• Expectations that future inflation will increase - Real estate rate always rises with inflation, hence cap rate would increase in this case.

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