When forecasting the current and potential future performance of commercial real estate assets, two of the most important metrics to pay attention to are the capitalization rate (cap rate) and interest rates.
While many real estate investors are likely familiar with the terms cap rate and interest rate individually, they may not realize that there is a very important relationship between them.
In this article, we will provide an overview of cap rates and interest rates and explore the relationship between them. By the end, readers will have a better understanding of how movements in these two metrics impact commercial real estate investment performance.
At First National Realty Partners, we carefully study all available data on both cap rates and interest rates and incorporate this information into our investment decision making process. To learn more about our current investment opportunities, click here.
What is a Cap Rate?
Cap rate in real estate is a metric that is used to describe the relationship between a property’s Net Operating Income (NOI) and its purchase price/market value. The formula used to calculate cap rate is:
Cap Rate = Net Operating Income / Property Value
In this equation, real estate investors can calculate NOI by subtracting operating expenses from total income, and the result provides some insight into the property’s operational efficiency.
As it relates specifically to this post, cap rates also represent a real estate market’s assessment of the risk associated with purchasing a property.
Lower Cap Rates
A lower cap rate means that the property is judged to have less risk, which usually means slow, steady, reliable growth in net operating income. Traditionally, property types like multifamily or those with financially strong tenants tend to fetch the lowest cap rates (highest prices).
Higher Cap Rates
A higher cap rate means that the market judges the property to have more risk, which means that investors need to earn a higher rate of return to purchase it. As a result, the price will be lower. 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.
What Are Interest Rates?
In the simplest terms, interest rates reflect the cost to borrow money. As it relates to commercial real estate investment, there is one interest rate that is more important than all others, the so-called “risk free rate.”
Risk Free Rate
The risk free rate is the rate paid on the United States 10-year treasury. In other words, it is the rate that the United States government is willing to pay to borrow money for 10 years. It is called the “risk free rate” because making a loan to the government is as risk free as an investment gets. Investors can be nearly certain that they will be repaid, with interest, and on time.
But, from a real estate investment perspective, the issue with the 10-year treasury is that the return on investment can be quite low. In the past 5 years, the rate has ranged from .50% to ~3.25%, depending on market conditions. For many investors, this is not going to cut it from a return perspective.
So, the question investors must ask themselves is, how much more risk am I willing to take in an effort to chase a higher return? This is where the relationship between cap rates and interest rates comes into play.
What Is The Relationship Between Interest Rates and Cap Rates?
The first important point to know about both cap rates and interest rates is they are not static. They are constantly changing, and the changes can materially impact real estate valuations.
Changes in the 10-year Treasury rate are driven by a variety of factors, but the most prominent are economic conditions and investor demand. During economic downturns, investors tend to flock to the safety of Treasuries, which drives prices higher and rates lower.
Factors that Drive Cap Rates
Changes in cap rates are also driven by a variety of factors, but the most prominent is supply/demand and growth expectations. In situations and markets where there is low supply and high demand, investors are willing to accept a lower return because they perceive there to be less risk. As such, cap rates tend to fall and prices tend to rise. Put another way, investors are willing to pay more for potential growth.
The difference between 10-year Treasury rates and cap rates is known as the “risk premium,” and it represents an investor’s compensation for taking the incremental risk associated with purchasing a real estate property versus a 10-year Treasury. For example, if the treasury yield is 2.00% and a property’s sales price implies a cap rate of 6.00%, the “spread” of 4.00% is the extra return for the higher risk of a CRE investment property.
Spread Between Treasury Rates and Cap Rates
Depending on market conditions, the spread between treasury rates and cap rates expands and contracts. Historically, the spread ranges from 2% – 4%. When the spread is at the higher end of this range, it signals the potential returns going forward may be higher. When it is at the lower end of the range, the market is signaling lower returns ahead.
How Do Interest Rates Affect Property Values?
Rising interest rates make it more expensive to borrow money, which lowers the potential returns for real estate investors. To compensate for this, investors must adjust market values lower. So, as a general rule of thumb, higher interest rates tend to lead to lower market values (or at least slower growth).
When interest rates fall, the reverse is true: borrowing costs are lower, which means that the net cash flow available to investors is higher. As a result, property pricing tends to rise.
Are Certain Property Types Affected Differently?
The above statement is true for the relationship between property values in general, but not all are affected equally. For example, multifamily assets tend to be viewed as less risky, and the government has loan programs designed specifically to support the country’s housing needs. For this reason, interest rates tend to have less of an impact on multifamily prices when compared to a riskier property type like a hotel.
How Are Cap Rates and Interest Rates Used in Private Equity Deals?
Cap rates and interest rates have a crucial role to play in private equity real estate transactions. This is because all private equity CRE transactions require the creation of a pro forma projection of a property’s rental income and operating expenses over a defined holding period. This pro forma includes key assumptions about cap rates and interest rates.
Use of Cap Rates
With regard to cap rates, private equity firms must make an assumption about cap rates at two points in the transaction. When purchasing the property, an assumption must be made about the cap rate to estimate the purchase price. Then, at the end of the holding period, a cap rate assumption must be made to estimate the potential sales price. However, it is important to note that these are both estimates and could end up being very close, or they could be off by a wide margin. The implications for returns can be significant.
Use of Interest Rates
Interest rates are important because they can affect the amount of money that is ultimately received by investors. If a loan has a fixed interest rate for the duration of the holding period, this is not hard to project. However, many lenders offer variable interest rates that change based on certain triggers. This type of loan can make it much more difficult to project interest rates, and returns, over a multi-year holding period.
The best private equity firms take a data driven approach to cap rate and interest rate projections and use them as part of a broader investment strategy. Potential real estate investors should ask about their process to ensure they are comfortable with it.
Summary & Conclusions
In real estate investing, the capitalization rate is a performance metric that describes the relationship between a property’s net operating income (NOI) and current market value. The formula used in the cap rate calculation is Net Operating Income / Value.
Interest rates reflect the cost of borrowing money. Within the context of real estate valuation, the most important interest rate is the one paid on the 10-year US Treasury, sometimes called the risk free rate.
There is a distinct relationship between cap rates and interest rates. The difference between the two is known as the risk premium that represents the incremental compensation an investor will receive for taking the risk of purchasing a real estate asset versus a Treasury. Historically, this risk premium ranges from 200 – 400 basis points (2% -4%), but it expands and contracts based on market conditions and expectations for future economic growth.
As a general rule of thumb, rising interest rates are bad for property values and falling rates are good.
Both cap rates and interest rates are important inputs into a private equity pro forma and can have a significant impact on a property’s profitability.
Interest In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.