Understanding Cap Rates in Real Estate: An In-Depth Analysis of its Correlation with Interest Rates

axxis real estate llc


November 27, 2023

In the dynamic world of commercial real estate (CRE), grasping the relationship between capitalization rates (cap rates) and interest rates is essential. This connection is particularly crucial for investors, especially in times of economic fluctuation. Here, we delve into what cap rates and interest rates are, and explore their intricate interplay.

What are Cap Rates and Interest Rates?

Cap Rates:

  • Definition: Cap rates signify the expected return on a real estate investment, calculated by dividing the net operating income (NOI) of a property by its current market value.
  • Formula: Cap Rate (%) = Net Operating Income ÷ Market Value of Property.

Interest Rates:

  • Definition: Interest rates represent the cost of borrowing money in financial markets.
  • Benchmark: Often benchmarked against U.S. government securities, known as the “risk-free rate”.

The Relationship Between Cap Rates and Interest Rates

Understanding the dynamics between cap rates and interest rates is key in navigating the real estate cycle’s stages: Recovery, Expansion, Hyper-Supply, and Recession. Each stage uniquely impacts the real estate market, influencing supply, demand, and pricing.

The correlation between cap rates and interest rates is not straightforward. Generally, rising interest rates lead to increased cap rates, implying a decrease in property values, and vice versa. However, real-world data often demonstrate more complex patterns beyond these general trends.

Commercial Real Estate (CRE) as an Inflation Hedge

In times of inflation, real estate is often viewed as a hedge. Interestingly, historical data show that cap rate spreads sometimes compress, contrary to the expectation of expansion. Growth in NOI and rental prices also play significant roles in this dynamic.

Understanding the Risk Premium

The risk premium, the difference between the cap rate and the yield on the 10-year Treasury note, reflects the additional return required for investing in real estate over risk-free securities. This spread varies, influenced by various market conditions.

Impact of Interest Rates on Property Values

Property values are shaped by several factors, including borrowing costs, location, quality, credit risk, and leverage ratio. High interest rates typically reduce market demand and property values, while low rates have the opposite effect.


While there is a correlation between cap rates and interest rates, their relationship is intricate and influenced by multiple factors. For real estate investors, understanding this complex connection is vital for making informed decisions in various market conditions. As interest rates and market dynamics evolve, so do cap rates, and savvy investors who grasp this nuanced relationship can strategically navigate the CRE market.

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