Understanding cap rate vs interest rate analysis is vital to your investment strategy today. Commercial real estate transaction volumes fell 30% to $244 billion in 2023, reaching a 10-year low. This makes the relationship between these rates even more important to your returns. A 2016 white paper by TIAA Global Real Assets revealed a positive correlation of 0.7 between cap rates and interest rates from 1992 to 2015. Yet this relationship remains complex.
The current market shows interesting trends in how interest rates affect cap rates. Core sectors have seen cap rates expand by 190 basis points. Office and multifamily sectors lead this expansion with increases of 255 and 195 basis points. Property types respond differently to rate changes. A 100-basis-point shift in the 10-year Treasury yield causes cap rate movements ranging from 41 basis points for industrial assets to 78 basis points for retail properties. The relationship’s unpredictability becomes clear in historical data. US Treasury yields and cap rates showed substantial correlation swings between -0.82 and 0.79 from 1983 to 2013. This proves that cap rate responses to interest rate increases remain hard to predict.
Understanding Cap Rates and Interest Rates in Real Estate
You need to understand what cap rates and interest rates represent in the real estate market before seeing how they relate to each other. These two metrics are the life-blood of real estate investment analysis. They help evaluate potential returns and measure risk.
Cap Rate Formula: Net Operating Income ÷ Property Value
The capitalization rate—cap rate for short—shows a property’s expected rate of return based on its income-generating potential. This metric reveals the unlevered yield of a real estate investment, assuming it’s purchased with cash rather than financing.
The formula for calculating cap rate is simple:
Cap Rate (%) = Net Operating Income (NOI) ÷ Property Value
Net Operating Income shows a property’s annual income after you take out all operating expenses but before debt service. These expenses usually include property taxes, insurance, maintenance, utilities, and management fees. Mortgage payments and interest expenses don’t factor into NOI calculations because they’re financing costs, not operational expenses.
Let’s look at an example. A property brings in $500,000 in gross income and has $250,000 in operating expenses. This means its NOI would be $250,000. If this property’s market value is $4,000,000, the cap rate would be 6.25%.
Cap rates usually fall between 4% and 12%, based on several factors. A property with a 10% cap rate would take about 10 years to earn back the invested capital through income alone. Higher cap rates often mean higher perceived risk, while lower cap rates point to lower risk but smaller potential returns.
Interest Rate Basics: Cost of Borrowing and Risk-Free Rate
Interest rates show what borrowers pay lenders to use money, shown as a percentage of the borrowed amount. These rates directly affect how much it costs to finance property purchases, developments, and renovations.
The risk-free rate sets the foundation for interest rates—it’s what an investor can expect to earn without any risk of losing money. U.S. Treasury bills or bonds serve as risk-free rate indicators because the U.S. government backs them fully.
A 10-year U.S. Treasury yield of 3.5% sets the baseline return for measuring other investments. Real estate investors must earn more than this risk-free rate to make up for taking on extra risk.
The gap between a property’s cap rate and the risk-free rate is called the “risk premium”—the extra return investors want for choosing real estate over risk-free investments. Take a shopping center with cap rates around 6.50% when the risk-free rate is 2.50%. The risk premium would be 4%.
Why These Metrics Matter to Real Estate Investors
Cap rates and interest rates working together can shape your investment strategy. Here’s why you should know both metrics:
- Valuation Impact: Rising interest rates make borrowing more expensive and can lower property values. Cap rates must increase to keep the same risk premium when the risk-free rate goes up, which leads to lower property prices. This works the other way too—falling interest rates often mean lower cap rates and higher property values.
- Investment Decisions: Cap rates let you compare different investments. A 10% cap rate might look better than 3%, but that higher rate often signals more risk. Your choice should match your risk comfort level and investment goals.
- Financing Strategy: Interest rates affect your borrowing costs and cash flow. Low interest rates help you get better financing terms, which might boost your returns through leverage.
- Market Timing: Knowing how these rates work together helps you time investments better. You might wait to buy if interest rates are climbing but cap rates haven’t adjusted up yet, as values could drop.
- Risk Assessment: The difference between cap rates and interest rates shows risk levels. Smaller gaps might mean overvalued properties, while bigger gaps could signal good buying chances.
Cap rates change a lot based on property type, location, and market conditions. Properties in popular areas usually have lower cap rates because investors see them as safer bets. Different properties react differently to interest rate changes. Office buildings, for example, showed a 65 basis point rise in cap rates for every 100 basis point change in mortgage debt compared to GDP.
Interest rates affect real estate markets in many ways beyond just financing costs. They influence credit availability, capital flows, and overall economic growth—factors that end up affecting property values and rental income.
Real estate investors who want to build the best portfolio in today’s complex rate environment should understand these relationships well. Think about how these metrics might change with economic conditions and what that means for your returns before making your next investment move.
Theoretical and Historical Relationship Between Cap Rates and Interest Rates
The cap rate-interest rate relationship shows complex interactions that casual observers often miss. Simple models suggest perfect correlation, but real-life data shows a more detailed picture of these metrics’ interaction throughout economic cycles.
Real vs Nominal Interest Rates: Effect on Cap Rates
Real and nominal interest rates create a fundamental difference in cap rates’ response to economic changes. Financial news typically quotes nominal interest rates which include inflation expectations and real returns. Real interest rates show the inflation-adjusted return rate and give a better view of actual economic growth.
Cap rates usually line up more with real interest rates than nominal ones. This makes sense because real estate acts as an inflation hedge. Property values and income streams adjust upward with rising inflation. This neutralizes the inflation part within nominal interest rates.
Let’s look at a practical example: Your property generates a 5% cap rate during 6% inflation. Both your net operating income and property value match inflation’s pace. Your cap rate stays at 5% even with changing nominal rates. Inflation gets removed from the equation. The cap rate then works mainly as your expected real return rate.
This explains why cap rates don’t always rise with nominal interest rates increasing from inflation expectations. Real estate can pass inflation through rental increases. Properties keep their value position compared to other assets. Your investment returns depend more on real interest rate movements that show true economic changes.
Historical Correlation: 10-Year Treasury vs Cap Rates (1992–2015)
The cap rate-interest rate relationship shows fascinating patterns over time. TIAA Global Real Assets’ 2016 white paper found cap rates had a 0.7 positive correlation with 10-Year Treasury yields from Q4 1992 to Q3 2015. This shows a moderately strong long-term connection between these metrics.
A deeper look reveals this correlation varies across different periods. Morgan Stanley found US Treasury yields and cap rates correlation changed between -0.82 and 0.79 from 1983 to 2013. These numbers show both positive and negative correlation periods, highlighting this relationship’s complexity.
Here are specific examples showing this variability:
- 10-year Treasury yields increased from 3.6% to 5.1% (Q2 2003 to Q2 2006), yet apartment cap rates fell from 7.6% to 6.4%
- 10-year yields climbed from 1.6% to 3.0% (Q3 2016 to Q4 2018), while cap rates barely changed, dropping slightly from 5.6% to 5.5%
- Apartment cap rates hit record lows as 10-year rates rose from 0.7% to 1.5% (Q3 2020 to Q4 2021)
Morgan Stanley studied eight key periods of rising corporate bond rates and/or 10-year Treasury yields. Cap rates moved opposite to expectations in five of these eight periods. This challenges the simple view that rising interest rates always lead to higher cap rates.
Hotel properties, without the “lease friction” found in other commercial properties, showed different patterns. Their cap rates changed by one quarter of one percent for each percentage-point change in the 10-year Treasury rate.
Lag Effect in Cap Rate Adjustments Due to Appraisal Timing
The lag effect in real estate valuations adds another layer to the cap rate and interest rate relationship. Real estate valuations use older data, unlike publicly traded securities that update prices instantly.
Several factors cause this appraisal lag. Appraisals use historical comparable sales from months earlier. Transaction recordings by local municipalities take several months. Private real estate’s periodic appraisal-based valuations smooth out reported values.
This lag creates significant effects. Reported cap rates might not show immediate changes during fast interest rate movements. This creates a time gap between these metrics. Morgan Stanley confirmed this – even one-year forward cap rate measurements showed inconsistent relationships with interest rates.
Morgan Stanley adjusted cap rates by one year to study this lag. Correlations between cap rates and Treasury yields stayed low even after these adjustments. This weak correlation suggests other factors beyond interest rates drive cap rate changes.
Market changes highlight this disconnect clearly. NCREIF data showed spreads between cap rates and Treasury yields reached just 0.29% in 2007’s second quarter during the pre-crisis market peak. This spread grew to 4.42% by 2010’s third quarter as market sentiment changed during the financial crisis.
Smart investors know they can’t view cap rates and interest rates alone. Credit availability, capital flows, risk premiums, expected rent growth, and other investment options all affect how cap rates respond to interest rate changes.
Schedule a strategy call with Primior (https://primior.com/start/) to learn how these factors might affect your portfolio.
Macroeconomic Drivers That Distort the Cap Rate–Interest Rate Link
Several powerful macroeconomic forces often break the theoretical link between cap rates and interest rates. Looking at why cap rates don’t always follow interest rates, three factors stand out as major disruptors.
Inflation Expectations and Real Estate as an Inflation Hedge
The way cap rates react to interest rate changes depends heavily on inflation expectations. Studies show that real estate works well as a hedge against inflation. This explains why property values might hold steady when interest rates go up because of inflation rather than actual rate increases. Property values might even rise as nominal interest rates climb, which seems counterintuitive at first.
Historical data tells us that cap rates often go down when inflation rises. This surprises many investors, but it makes sense because people rush to buy real assets during inflationary times. More competition for properties naturally drives values up.
The difference between real and nominal interest rates is vital here. Real estate can usually pass inflation-driven costs to tenants through higher rents when nominal rates climb solely due to inflation expectations. We’ve seen cap rates drop across office, industrial, retail, and multifamily properties in response to inflation.
Credit Availability and Capital Flows
The availability of credit and movement of capital can affect markets more than interest rate changes. Here are two interesting examples:
U.S. Treasury rates jumped 191 basis points between October 1998 and May 2000. Commercial real estate mortgage volume grew by over $450 billion during this time. Cap rates actually dropped by 32 basis points despite rising rates.
The opposite happened from December 1989 to October 1990. Treasury rates went up just 88 basis points, but lending fell by over $50 billion. This caused cap rates to spike by 68 basis points right away and 150 basis points a year later.
Linneman’s research shows that capital flows shake up real estate values whatever the interest rates do. His study found that when mortgage debt grows 100 basis points faster than GDP, cap rates go up by 22 basis points for multifamily properties and 65 basis points for office properties. This helps explain why deals slow down and prices fall when investors pull back and lending gets tight.
Unemployment and GDP as Predictors of Cap Rate Movement
GDP growth and unemployment rates often tell us more about where cap rates are headed than interest rates alone. Cap rates usually drop during good economic times with high GDP and low unemployment. Investors feel more confident and see less risk.
Bad economic conditions push cap rates up as investors want better returns to make up for higher risks. Linneman found that rising unemployment makes cap rates inch up across different types of properties.
This works both ways. Strong GDP growth and low unemployment can push cap rates down even when interest rates are climbing. That’s why we’ve seen cap rates fall despite rising interest rates during periods of solid economic growth.
The real story behind cap rate changes has more to do with these economic conditions than interest rate shifts. Real estate investors who understand these complex relationships can turn challenging markets into opportunities for better returns.
