Recent commercial real estate transactions have contracted cap rates in Australia to historic lows. In Australia, for example, the cap rates for top commercial buildings have historically oscillated between five percent and six percent, but recent transactions have seen top buildings transacting at below five percent.
Concerns are raised among real estate investors on the Australian real estate price level, especially since other real estate markets such as Hong Kong and Singapore are also at or around historical peaks.
We believe that cap rates are useful as a back-of-the-envelope metrics, but it is too crude to be a standalone indicator of market pricing level. Cap rate is a simple concept, as it is derived by dividing the expected Net Operating Income of the next twelve months by the capital value of the building.
Net Operating Income typically is the rental revenue minus property level outgoings, which in most advanced economies include real estate tax, insurance, and the salary of staff tied to the building. Thus, the cap rate is a modified rental yield.
Cap rates as valuation technique
The commercial real estate industry, including both REIT and direct real estate investors, often uses cap rates as a valuation technique because of its ubiquity.
An analyst can approximate the cap rate for any transaction as long as the capital value is announced, and therefore, any dedicated investor can keep a good record of cap rates simply by keeping track of all recent transactions in an interested market.
Ultimately, however, investment decisions are made on a total return basis and not just the current passing yield. This, instead of relying exclusively on cap rates, institutional investors likely use a hurdle rate, or something similar, as their deciding metric.
In fact, the cap rate reflects the observation of the current state of the market, with the market pricing driven by the collective actions of the hurdle rates of various investors. Thus, historical cap rate comparisons are only useful when the hurdle rate moves within a well-defined band.
The global capital market has changed significantly in the last two decades. The most discussed aspect is the reduction in US Dollar and Euro interest rate levels since the Global Financial Crisis.
But this reduction is also clearly cyclical, as evidenced by the fact that US Dollar interest rates are widely anticipated to now be on an uptrend. The interest rate cycle also mainly impacts government bond interest rate, which influences but does not determine the hurdle rate of various other assets such as real estate.
More secular change
We believe that a more secular change came from the diversification of institutional investor sources. The rising wealth in Asia has prompted several governments to set up sovereign wealth funds, and many Asian families are reaching the level that they are institutionalising their portfolios into family offices. This development adds the number of institutional investors.
In 1994, the American Law Institute accepted into its trust law report the Prudent Investor Rule, which updated the Prudent Man Rule and allowed institutional investors to diversify into asset classes beyond stocks and bonds.
Since then, institutional investors from the US, Europe and eventually Asia became more sophisticated in deploying capital into real estate and other asset classes.
Institutional investors in the UK, for example, went from an average allocation of 65 percent in stocks in 2003 to less than 40 percent in 2015, with investment in real estate rising from nothing to about 20 percent.
In recent years, we are also observing similar changes in institutional investors and family offices in Asia Pacific. This development means that many more investors are now looking at real estate as part of their long-term allocation and permanently adding capital to the sector.
We recognise that real estate is an interest rate sensitive asset class and that a rising interest rate environment will influence future real estate price. However, the increased number of institutional investors and their gradual expansion into real estate should mean that more capital is in the sector.