Cap Rates and Interest Rates

How Do Rising Interest Rates Affect Cap Rates?

The interest rate environment is an influential factor in property valuations, namely because interest rates reflect the cost of borrowing, i.e. the cost of debt (kd).

Higher interest rates coincide with higher borrowing costs and reduced property valuations.

• Rising Interest Rates → If interest rates rise, the cost of borrowing increases in tandem, effectively reducing the purchasing power of market participants and the affordability of properties. The rise in borrowing costs amid periods of high-interest rates in the economy is representative of unfavorable conditions for investors, as their access to the financing needed to fund acquisitions becomes restricted.
• Declining Interest Rates → If interest rates fall, the cost of borrowing declines, meaning there is more “cheap” capital readily available, which increases the purchasing power of property investors and causes demand in the market to spike since properties are now more affordable.

Since real estate investors face more risk – in terms of not generating sufficient returns (or even incurring monetary losses) – most investors require a higher return to compensate for the incremental cost of borrowing.

Given the sharp reduction in market demand from buyers and increased competition among sellers, the asking price of properties is usually trimmed (and sellers offer more incentives to entice buyers).

Why? Higher interest rates tend to impede demand in the market from potential buyers, forcing sellers to offset the higher cost of financing by reducing the price tag of their properties.

A reduced purchase price causes returns to increase – all else being equal (i.e. “buy low, sell high”).

^{Why Rising Interest Rates Won’t Lead to Cap Rate Change (Source: GlobeSt)}

Are Cap Rates and Interest Rates Correlated?

Historical market data implies a strong correlation between interest rates and cap rates (and thus, property values).

Based on the current state of the economy, the spread between the yield on Treasury notes and cap rates can either expand (or contract).

• Increased Spread → More Potential “Upside” in Returns (and Greater Risk)
• Decreased Spread → Less Potential “Upside” in Returns (and Less Risk)

So, the question here is, “Do inflationary periods cause the spread between the cap rate and interest rate to expand?”

Contrary to a common misconception, the cap rate spreads often compress amid rising inflation.

The contradictory historical data is perhaps attributable to more investors perceiving the real estate asset class as an inflationary hedge in their portfolio.

While interest rates and cap rates are indeed closely connected, there are decades of historical data that contradict the broad generalization that inflation and rising interest rates cause the spread to expand.

The real estate asset class has proven to be an effective hedge against inflation based on recent data, with all four sectors – office, industrial, retail, and multifamily – reacting to inflation with cap rate compression.

The takeaway is that there are other components, such as the percent growth in rental prices and net operating income (NOI), that can offset the increased cost of borrowing.

1. Increase / (Decrease) in Interest Rates
2. Growth in Net Operating Income (NOI)
3. Growth in Rental Prices

In short, the interaction between cap rates in the real estate market and interest rates is complicated.

^{Rising Interest Rates and the Future of Commercial Real Estate (Source: NYU)}

Cap Rates vs. Interest Rates: What is the Risk Premium?

The risk premium measures the relationship between the cap rate and interest rate.

The risk premium is the percent difference between the cap rate and the yield on the 10-year Treasury note.

Conceptually, the risk premium is the incremental compensation for investing in a commercial real estate property in lieu of a risk-free security, i.e. the 10-year Treasury note.

For example, suppose the 10-year Treasury yield is 3.0%, while the implied cap rate on a potential renal property investment is 8.0%.

The cap rate spread is 3.0%, which reflects the incremental return received by the real estate investor for placing their capital in a higher-risk property investment instead of a risk-free government bond issuance.

• 10-Year Treasury Yield (%) = 3.0%
• Cap Rate (%) = 8.0%
• Cap Rate Spread (%) = 8.0% – 3.0% = 5.0%

The spread between cap rates and the yield on U.S. Treasury notes fluctuates continuously based on the changes in market conditions and the state of the economy.

Historically, the cap rate spread ranges between 2.0% and 4.0% in normalized market conditions.

• Higher Cap Rate Spread (%) → Higher Potential Yield (and More Risk)
• Lower Cap Rate Spread (%) → Lower Potential Yield (and Less Risk)

How Do Interest Rates Impact Property Values?

The property values in the real estate market are determined by a multitude of factors, including the following:

• Cost of Borrowing → The interest rate is the cost of borrowing. Therefore, lenders can obtain debt financing more easily at favorable interest rates.
• Property Location and Condition → The location in which the property is situated and the current state of the property are indirectly influenced by the market interest rate. If demand for properties increases, there is more competition in the market, which causes prices to climb (and vice versa).
• Property Type → The properties of higher quality (i.e. “Class A”) are perceived as less risky, while properties of lesser quality (“Class C”) are riskier and warrant higher spreads. In periods of low interest rates, the number of buyers in the market that can afford to purchase higher-quality properties increases.
• Credit Risk (DSCR) → The minimum debt service coverage ratio (DSCR) of commercial lenders is normally a DSCR between 1.20x and 1.25x. The lower the interest rate, the easier the DSCR target can be reached (and vice versa).
• Leverage Ratio (Loan-to-Value Ratio) → The maximum loan-to-value (LTV) ratio is usually set near 75% for commercial loans, but other risk factors can influence the debt capacity of the property (and the amount that risk-averse lenders are willing to provide in a financing arrangement). The higher the interest rate, the less debt can be offered, as one of the credit metrics used to analyze the risk of default of a potential borrower is the interest coverage ratio.

Therefore, in a high-interest rate environment, the buyers in the market possess less buying power, resulting in a steep drop-off in market demand.

Given the reduction in competition, the property values must often be adjusted downward (i.e. discounted) by the seller, or else a property will remain on the market for a prolonged period.

The rising interest rate signifies a higher cost of debt, which reduces the potential returns on a potential real estate investment.

• Buyer Perspective → From the perspective of a real estate investor, the economic incentive to engage in the market wanes.
• Seller Perspective → In response, sellers in the real estate markets must entice buyers by offering discounted pricing, incentives, etc.

Conversely, if interest rates declined, the borrowing cost would be “cheaper”, so securing loans with borrower-friendly terms expands the optionality of the buyers (and property prices tend to rise post-increase in market demand).

With that said, the general rules of thumb – per academic theory – on the impact of interest rates on property values are as follows.

• Higher Interest Rates (%) → Lower Market Values of Properties (Decreased Demand)
• Lower Interest Rates (%) → Higher Market Values of Properties (Increased Demand)

In conclusion, we’ll reiterate that the relationship between the cap rate and interest rates is intricate with various moving pieces. Therefore, it is important to analyze the root sources that are causing the discrepancies between academic theory and practical historical data.