The relationship between Cap Rates and Interest Rates in Real Estate

In real estate investment, many of the key metrics are interlinked, such as the relationship between cap rates and interest rates, for example. Indeed, both of these are important factors into a private equity pro forma as they can have a significant impact on a property’s profitability.

There may be a direct correlation between cap rates and interest rates but, bearing in mind that the values of some asset classes move independently of others and different markets will be at different stages of the property cycle, then such correlation may be indirect or of lesser significance.

Although we have discussed cap rates and interest rates previously it’s worth taking a few moments to state the basic premise of such metrics:

The capitalisation rate (“cap rate”) is a performance based metric which describes the relationship between a property’s net operating income (“NOI”) and its estimated current market value, or the anticipated rate of return in an all cash purchase.

The formula used to calculate it is: Net Operating Income / Property Value
Essentially, real estate investors calculate NOI by subtracting operating expenses from total income and the result provides some insight into the property’s operational efficiency.

Typically, a lower cap rate means that the property is considered to have less risk, which usually means steady, reliable growth in cash flow, with properties such as multi-family apartments or those with financially strong tenants having the lowest cap rates.

On the other hand, higher cap rates mean that the property is perceived to have more risk, and investors expect a higher rate of return and a lower price. Properties in riskier asset classes like hotels, restaurants, and office buildings or those that have large vacancies or operational issues tend to fetch higher cap rates.

Interest rates reflect the cost of borrowing money for REPE investment or projects either via a short-term loan or a longer-term mortgage. In real estate the most important interest rate is the one paid on the 10-year US Treasury note, often called the “risk-free” rate.

What is the 10-year Treasury note?

The 10-year Treasury note is a debt obligation with a maturity of 10 years upon initial issuance issued by the US government. This note pays interest at a fixed rate once every six months and pays or returns the face value to the holder at maturity.

The 10-year Treasury note is just one of a variety of securities issued by the US government, with others being: Treasury bills, also known as T-bills (short-term securities), and the longest term Treasury bonds, also known as T-bonds.

What is the current rate on 10 year Treasury notes?

Currently the rate on a 10 Year Treasury note is 2.81%, compared to around 1.66% last year, much lower than the long term average rate of 4.28%.

Often the interest rate on a 10 year (or even shorter) Treasury note is referred to as the “risk-free rate”, which is the theoretical rate of return of an investment with zero risk and represents the interest REPE investor expects from an absolutely risk-free investment over a specified period of time. Investors can be nearly certain that they will be repaid, with interest, and on time.

Why is the risk free rate important in real estate?

In real estate, cap rates and interest rates are related because conventional logic is that an investor expects to receive a return higher than the risk free rate in order to take the additional risk of purchasing a real estate asset.

Analysing the risk premium relative to historical trends can provide an important data point about the likely future trends of multi-family apartment real estate prices.

What is the key relationship between cap rates and interest rates?

There is a clear relationship between cap rates and interest rates during any real estate cycle. The difference between a cap rate and the risk free rate is usually called the “risk premium” which is the incremental compensation of investing in a commercial property asset compared with buying a Treasury note.

However, from a real estate investment perspective, the return on a 10-year Treasury note can be relatively low. Over the past 5 years, the rate has ranged from 0.50% to ~3.25%, depending on market conditions. However, for many investors this may not be quite enough considering the risks involved so they need to ascertain how much more risk they are prepared to take when seeking a higher return—hence the relationship between cap rates and interest rates.

It’s mainly economic factors and changes in investor demand which affect the 10-year Treasury rate. For example, during economic downturns, investors tend to move funds to the relative safety of Treasury notes which, in turn, drives their prices higher and rates lower.

Similarly, changes in cap rates are also driven by a wide variety of factors, with the most prominent being supply and/or demand and income growth expectations. In cases where there is a low supply of multi-family apartments and high demand, investors are usually willing to accept a lower return in view of the expected lower rate of risk.

As an example, if the Treasury yield is 2.50% and a property sells at a cap rate of 6.00%, the difference or “spread” of 3.50% is the extra return for the perceived higher risk of a CRE investment property.

This spread between Treasury rates and cap rates rises and falls depending upon market conditions and has historically ranged from 2% – 4%.

At times when the spread is at the higher end of this range, it indicates that the potential returns going forward may be higher. When the spread is at the lower end of the range, the market is indicating lower returns in the future or, in other words, a very narrow spread can indicate an increase in cap rates or fall in property prices.

What impact do changes in interest rates have on property values?

As interest rates increase and make it more expensive to borrow money this, obviously, lowers the potential returns for PERE investors. In order to maintain such returns, investors will endeavour to adjust market values to lower levels or at least try to find ways to keep returns close to previous levels.

Conversely, when interest rates fall, the reverse is true and as borrowing costs become lower, the net cash flow available to investors increase and property prices tend to rise.

Are all property types affected by changes in interest rates in the same way?

As property markets are not homogenous and different asset classes have different investment characteristics, whilst the foregoing is true in general not all properties are affected in the same way. As an example, partly in view of sustained demand, multi-family apartment assets are considered as less risky, plus there are a variety of government promoted loan programmes to support the country’s housing needs. As you might expect, therefore, interest rates tend to have less of an impact on multi-family properties when compared riskier property types.

How do cap rates and interest rates work in private equity transactions?

Investment into commercial real estate invariably requires the creation of an investment pro-forma meaning that levels of cap rates and interest rates are vitally important in REPE transactions. Projections for both rates can have a material impact on NOI and cashflows, and thereby affect future expectations of sales prices.

Assumptions need to be made about cap rates at two points in any real estate transaction. This will, firstly, be prior to an acquisition in order to make an offer and /or estimate the purchase price. Then, secondly, at the end of the holding period of the property, assumptions about a suitable cap rate need to be made to estimate the potential sales price.

Of course these are just estimates and the figures may end up being accurate or some way away from the actual results

When it comes to Interest rates, these are clearly important as they can affect the investment returns or amount of money ultimately received by investors. On one hand, if a loan has a fixed interest rate throughout the holding period, returns are easier to project and with more certainty. However, depending on the interest rate environment and outlook many offer loans attract variable interest rates which change based on certain occurrences, not least of which is a change in interest rates!. Naturally, this type of loan makes it more difficult to predict interest rates and, as a result, returns, over a holding period which stretches over many years .

Having been involved in numerous REPE transactions over the years, CPI Capital well understands the relationship between cap rates and interest rates and always takes a data driven approach to cap rate and interest rate projections, using them as part of a comprehensive broader investment strategy.

We always carefully consider the relationship between increases or decreases in cap rates and interest rates and their potential impact on the expected returns to our passive investors. By necessity we constantly monitor the 10-year Treasury note rates, as well as interest rates for other shorter notes

The interaction of these metrics are clearly important inputs into a private equity pro forma and we need to be able to adjust or tweak our strategy if required to maintain a property’s profitability.

Yours sincerely
August Biniaz
CSO, COO, Co-Founder CPI Capital