How Market Trends in 2024 are Affecting Cap Rates

Understanding how cap rates work can help investors balance risk and reward. They offer a quick way to see a property’s profitability and compare investment opportunities. But a question we often hear is, “What is cap rate?”

Keep reading to learn the meaning and importance of cap rates and how market trends in 2024 are shaping Canadian real estate investment opportunities.

Cap Rate Meaning 

Cap rate, short for capitalization rate, measures a property's return on investment (ROI) based on the income the property will generate.

To figure out the cap rate, you divide a property’s annual net operating income (NOI) — which is the property’s income minus operating expenses — by its current market value. The resulting percentage gives you a snapshot of the expected ROI.

Let’s calculate the cap rate for a $500,000 home renting for $2,500 per month:

Based on its annual rental income relative to its market value, the property is expected to generate a 6% return on investment.

Calculating the cap rate offers a quick way to see a property’s profitability and compare investment opportunities. A higher cap rate typically means a higher potential return but could also mean greater risk. A lower cap rate generally suggests a more stable investment with lower returns.

Overview of Market Trends in 2024       

The Canadian economy is struggling in 2024. Interest rates are steadily above target, and GDP growth is steady but modest. While inflation is cooling compared to last year, the cost of living is a concern, affecting how Canadians spend and invest.

These high interest rates have slowed home buying, especially in urban areas, leading to a drop in housing prices. But the rental markets are booming as more people find it harder to achieve homeownership. Commercial real estate is mixed — retail spaces are struggling, but industrial and multifamily properties are rising thanks to changing consumer habits and a focus on logistics. 

Factors Driving Cap Rate Changes in 2024

Here’s a look at how technology, sustainability, shifting work trends, and economics shape cap rates in today’s market.

Factor #1: Technology

More investors are using predictive analytics to assess market trends and forecast property values. This tool offers a better evaluation of potential returns and risks, making it easier to understand the complexities of cap rates in a volatile market.

Factor #2: Green and Sustainable Properties

Energy-efficient properties or those with eco-friendly certifications are becoming more popular with investors and tenants. These features can impact cap rates positively by enhancing property value and reducing operational costs, potentially improving returns.

Factor #3: Remote Work

The rise of remote work has shifted the focus to properties that cater to home offices and work-life balance. This trend affects cap rates as demand for suburban and rural properties with home office spaces increases. Investors might find higher cap rates in these areas as people move away from urban centres to find more spacious living arrangements.

Factor #4: Economics

A strong job market and rising wages can boost the demand for rental properties and impact rental income, influencing cap rates. As people earn more, they can likely afford rental units, driving up rental income. This surge in rental income can positively influence cap rates, as properties generating higher revenue become more attractive investments.

Impact of Market Trends on Cap Rates

Changes in interest rates directly impact cap rates. When interest rates rise, borrowing costs surge, leading to higher cap rates as investors want better returns to offset increased financing expenses. When interest rates fall, cap rates often decrease as the cost of borrowing is lower, making investments more attractive even with a lower return.

2024’s Canadian interest rates are high as the Bank of Canada continues to curb inflation. These elevated rates push cap rates higher, particularly in markets where financing costs greatly influence investment decisions. This trend makes some investors more cautious, especially in residential and commercial real estate.

Property Value Fluctuations

Property values also influence cap rates. When property values rise, cap rates usually decrease because the higher valuation means a lower return than the investment. When property values fall, cap rates often increase as the ROI needs to be higher to justify the purchase.

Canada's property values are fluctuating so far this year, particularly in urban centres. The cooling housing market, driven by high interest rates, has led to more stable or slightly declining property values. This trend has caused cap rates to rise as investors look for higher returns to balance the potential risk of further value drops.

Rental Income Trends

The rental income in Canada has increased in 2024, mainly because high home prices and interest rates are pushing potential buyers toward renting instead. The increase in rental income puts downward pressure on cap rates in the rental property sector, even as other factors like interest rates push them upward. 

Regional Variations in Cap Rates

Different areas have opportunities and challenges, with cap rates reflecting the local economic environment, demand, and property values.

Urban vs. Suburban

Cap rates are typically lower in urban areas compared to suburban regions. Urban properties often have higher prices and lower returns, showing strong demand and limited supply in cities. Suburban properties frequently have higher cap rates, offering better returns thanks to lower property values and potentially less competition.   

The current difference in cap rates between urban and suburban areas in Canada is becoming more noticeable. High interest rates and cooling housing markets have slowed down urban property investments, pushing cap rates slightly upward in cities. Suburban areas are seeing more stable or even dropping cap rates as demand for suburban living continues to grow, driven by remote work trends and affordability concerns in urban centres.

Geographic Differences

Areas with strong economic growth, high population density, and limited real estate supply typically have lower cap rates. In comparison, regions with slower growth or higher perceived risk have higher cap rates.

In 2024, regional trends in Canada are shaping cap rates in many ways. For example, cap rates in the Greater Toronto Area and Vancouver are low because of sustained demand despite rising interest rates. But, regions like Alberta and the Prairies are seeing higher cap rates as economic conditions remain more volatile, leading investors to look for higher returns to compensate for the increased risk. The Atlantic provinces are seeing a mix, with urban centres seeing lower cap rates thanks to growing demand, while more rural areas maintain higher cap rates.

Need Help Navigating the Shifting Market?

High interest rates are changing the real estate market, so investors need to know how these rates, along with shifts in property values and rental income, affect cap rates. Local conditions also play a role, so be sure to consider regional factors when looking at investment opportunities.

At Andra Arnold & Associates, we’re committed to helping you make sense of these trends and how they impact your real estate investments. Whether you’re looking to invest in urban or suburban properties or need insight into regional cap rate variations, we’re here to help. 

Get in touch today.