In commercial real estate, we talk about cap rates and interest rates all the time. These two numbers are key to property values, investment decisions and market performance. But the relationship between the two is more complicated than it seems. In this post we’ll explain how cap rates and interest rates are connected, how they affect commercial real estate and what you need to know to make smart decisions in today’s market.
What are Cap Rates and Interest Rates?
Cap Rate
A capitalization rate (cap rate) is a measure of the relationship between a property’s net operating income (NOI) and its purchase price or current market value. It’s the expected return on investment (ROI) for a real estate asset, expressed as a percentage. Cap rates help you decide if a property is a good investment by giving you an idea of the income compared to the price.
Interest Rate
Interest rates on the other hand are the cost of borrowing. The risk-free rate is often represented by the US 10 year Treasury rate which is the benchmark for borrowing costs across all markets. As interest rates go up it gets more expensive to finance real estate investments and directly impacts investor returns.
Cap rates and interest rates are both key metrics that affect the value of real estate and drive investment decisions. Let’s get into it.
Cap Rates and Interest Rates
The relationship between cap rates and interest rates is not always direct but is highly impactful. In theory as interest rates go up so do cap rates because borrowing becomes more expensive and investors demand higher returns to compensate for that. However, reality is more complicated.
Cap rates fluctuate based on economic conditions, investor demand and market sentiment. For example when 10 year Treasury rates go up cap rates tend to follow. But cap rates are also driven by supply and demand in real estate so the relationship is more complicated than a one to one correlation.
What Affects Cap Rates
Several things affect cap rates in commercial real estate:
Supply and Demand: In high demand low supply markets investors will accept lower returns (lower cap rates) because they perceive the risk to be lower. In oversupplied markets cap rates will rise as the perceived risk increases.
Credit: The availability of credit can affect cap rates. When credit is cheap and easy to get cap rates compress as more investors can get into the market.
Growth: Investors will accept lower cap rates if they believe the property or market will grow over time and therefore future appreciation and rental income growth.
What Happens When Interest Rates Go Up
When interest rates go up the cost of borrowing money increases and it gets more expensive for investors to finance property purchases. So many investors expect higher returns to justify the increased cost of debt and that means higher cap rates. Here’s how rising interest rates affect real estate:
Higher Borrowing Costs: With higher interest rates financing gets more expensive and leveraged real estate deals become less profitable. That means cap rates go up as investors demand more returns.
Lower Property Values: Higher cap rates mean lower property values. As cap rates go up the market price of properties must go down to reflect the reduced attractiveness of the investment.
Increased Risk for Investors: As the cost of borrowing goes up real estate investments become riskier especially if the property’s income doesn’t keep pace with the increased debt service. In that case investors demand higher returns to compensate for the added risk.
NOI in the Cap Rate Formula
A property’s Net Operating Income (NOI) is a key component in the cap rate calculation. NOI is the total income of the property after operating expenses have been subtracted but before mortgage payments and taxes.
Here’s the simple formula:
Cap Rate = NOI / Property Value
Example: If a property has an NOI of $500,000 and a market value of $10,000,000
5% = $500,000 / $10,000,000
In this case the cap rate is 5% so the investor can expect a 5% annual return based on the current NOI.
Risk Premium and Spread between Treasury Rates and Cap Rates
One important thing to consider when looking at the relationship between cap rates and interest rates is the risk premium, which is the additional return investors demand for taking on the risk of real estate vs a risk free asset like U.S. Treasury bonds. The spread between 10 year Treasury rates and cap rates can expand or contract based on market conditions.
The spread is usually 2% to 4% but can vary depending on economic conditions, market sentiment and risk tolerance. When Treasury rates go up and the spread narrows cap rates go up to maintain the risk premium for investors.
Cap Rate vs Interest Rate
For real estate investors understanding the cap rate vs interest rate dynamic is key to making good investment decisions. As interest rates go up cap rates follow and that puts downward pressure on property values. But it’s not always linear as other factors like market demand, credit availability and economic growth come into play.
Investors must consider how interest rate changes will impact their ability to finance deals and the long term value of their properties. A rise in cap rates means it’s time to revalue properties and make decisions to hold, sell or buy new assets.
Investing in a Rising Interest Rate World
In a rising interest rate environment investors should be careful with deploying capital and consider how increased borrowing costs will reduce profits. Here are a few ways to navigate:
Cash Flow: Focus on properties that will generate strong cash flow even in a higher interest rate environment. These properties are less interest rate sensitive.
Invest Opportunistically: Rising interest rates may bring distressed sales or discounted properties. Savvy investors can buy at lower prices.
Hedge Interest Rate Risk: Investors can hedge interest rate risk by getting fixed rate financing which locks in the borrowing cost for the life of the loan.
Interest Rates and Property Values
Property values are very interest rate sensitive. When interest rates go up buyers have less purchasing power so fewer people can afford to buy at high prices. This reduced demand forces sellers to lower their asking prices or face longer listing periods. When interest rates are low borrowing is cheaper and buyers have more purchasing power and property values go up.
Private Equity and Cap Rates
In private equity real estate deals cap rates and interest rates are key to the deal structure and investment returns. Private equity firms use cap rates to project future income and property values so assumptions about interest rates and cap rates are critical to getting the pro forma right.
For example if a private equity firm expects interest rates to rise they may assume higher cap rates in their valuation models which would reduce the sale price and overall return on investment.
Market Trends and Outlook
Current market trends indicate interest rates will continue to go up which will put pressure on cap rates. According to the Urban Land Institute’s Real Estate Economic Forecast interest rates will peak soon and cap rate expansion will continue through 2023. But as inflation stabilizes cap rates will normalize in 2024 and that will be the window of opportunity for investors to buy assets at good prices.
Summary
Cap rates and interest rates are fundamental to commercial real estate investors. As interest rates move cap rates move and cap rates impact property values and returns. Understanding this allows investors to navigate the market and make decisions to buy, hold or sell.
Rising interest rates can be a challenge but also an opportunity for investors who can adjust their strategy and ride the market. By watching cap rate trends and interest rate movements real estate professionals can be ready for whatever comes next.