Cap Rates and Interest Rates: Unveiling the Connection

Evaluating real estate investments requires tracking multiple market indicators, two significant metrics being capitalization rates and interest rates. Statista forecasts an increase in average commercial real estate cap rates from 6.1% in 2024 to around 5.7% by 2026, so investors need to keep a particularly close eye on these metrics. Simultaneously, the Federal Open Market Committee predicts interest rates will ease in the coming years. Amid these shifting forces, comprehending how cap rates and interest rates interact can help shape commercial real estate investments.

We'll explain how cap rates and interest rates work and how their relationship impacts real estate investing across different market conditions. You'll also learn strategies to boost returns and handle risks when these rates fluctuate. Understanding the cap rate-interest rate connection will sharpen your ability to pinpoint profitable real estate markets. So, if you're ready to up your real estate game, you've come to the right place!

Understanding cap rates

The capitalization rate, or cap rate for short, tells you the potential return you could make on a property investment compared to the purchase price. It's calculated by taking the property's net operating income (NOI) and dividing it by the current market value.

The net operating income is the yearly income from rent and other sources after paying operating expenses like taxes, insurance, and maintenance, but before factoring in the mortgage payment.

A higher cap rate signals a higher potential return but could also indicate more risk or issues with the property's location or condition. A lower cap rate usually means a more stable investment, though with a lower return.

For example, if a property generates $100,000 in NOI per year and the purchase price is $1.5 million, the cap rate would be:

Cap Rate = $100,000 / $1,500,000 = 6.67%

So, a 6.67% cap rate represents the potential return before financing costs.

The role of interest rates

Interest rates are the fee you pay to borrow money from a lender, usually as a percentage of the loan amount. In real estate, higher interest rates equate to a higher cost to finance a property purchase using a mortgage or other loan.

When an investor borrows to buy a property, that interest rate determines their borrowing costs over the loan period. Higher interest rates mean higher financing expenses that can eat up the property's potential cash flow and profits.

Interest rates reflect different factors, including monetary policies set by central banks, economic conditions, inflation rates, and the overall demand for credit in the market. Lenders consider the borrower's creditworthiness, loan-to-value ratio, and the type of property when determining the interest rate for a specific loan.

If an investor gets a $1,000,000 loan to buy a property at a 5% annual interest rate, they'd have to pay $50,000 in interest for the first year (5% of $1,000,000). A real estate investor needs to consider this extra cost when deciding whether the investment makes financial sense.

How cap rates and interest rates interact throughout the real estate cycle

The relationship between cap rates and interest rates varies depending on the phase of the real estate cycle. Here's how they interact:

Recovery

During the recovery phase, when the market is getting better after a downturn, cap rates are usually high. This exemplifies that investors are cautious because there are still risks during the recovery.

Property prices might be low, so investors expect higher profits to compensate for the uncertainties. At the same time, interest rates are usually low because central banks want to help the economy grow.

When high cap rates and low-interest rates happen at the same time, it presents a great opportunity for investors. They can buy investment property at a lower purchase price and secure low financing costs, which can create higher returns.

Expansion

During expansion, when the market is growing and property prices are rising, cap rates usually drop. This is because more people want to invest in real estate, and they feel it's less risky. In this phase, investors might be fine with making less profit because they expect property values to keep increasing.

At the same time, interest rates might start to rise as the economy strengthens and central banks adjust their policies. Rising interest rates can make loans more costly, which might offset some of the advantages of lower cap rates.

Hyper-supply

In a hyper-supply market where the number of available properties far outweights the demand, cap rates might go up. Investors want higher profits to make up for the risks of having too many empty properties or lower rental rates.

This phase can be challenging, because property owners face intense competition, which can push rents and property prices down. Interest rates can also change during this time, depending on the employment rate and the state of the economy.

With higher cap rates and changing interest rates, it can be hard for investors to decide when to buy or sell properties and at what prices.

Recession

During a recession, cap rates usually rise because investors become more cautious and want higher profits to deal with the risks of a weak economy. These risks could look like decreased property value, higher vacancy rates, and lower rents.

Interest rates fall as central banks try to help the economy by making it easier to borrow money and finance projects. With higher cap rates and lower interest rates, investors might have opportunities to buy properties with cheaper loans if they have the funds and are willing to take some risks.

Getting funding during a recession could be harder, because banks are stricter about who they lend to and how much they're willing to lend.

Interest rates and property values

Interest rates can influence property values in several ways:

• Cost of borrowing: Borrowing money becomes cheaper when interest rates are low. Lenders can offer better rates on loans and mortgages, making it easier for people to buy investment property.
• Property location and condition: Although not directly tied to interest rates, a property's location and condition influence its demand and value. Low interest rates generally increase demand for all properties, especially those in desirable locations or in good condition, leading to higher prices.
• Property type: Interest rate changes affect different property types differently based on their perceived risk. High-quality properties are less risky investments and see increased demand when interest rates are low. Lower-quality properties may struggle to attract buyers when interest rates rise.
• Credit risk (Debt service coverage ratio): Low interest rates make it easier for properties to meet debt service obligations, which boosts their attractiveness to lenders and can enhance their perceived value. Rising rates can strain a property's ability to cover debt payments, impacting its creditworthiness and value.
• Leverage ratio (Loan-to-value ratio): Properties with lower loan-to-value ratios have more equity and are less affected by interest rate changes since they rely less on borrowed funds. Properties with higher loan-to-value ratios exhibit greater sensitivity to rate fluctuations because they finance a larger portion of their value through loans.

Other economic indicators

Real estate investors should be aware of additional economic indicators and investment fundamentals that shape the relationship between cap rates and interest rates. These include:

10-year treasury note

The 10-year treasury note is a benchmark for interest rates, as its yield influences consumer and business lending rates, including mortgage rates. For real estate investors, the 10-year treasury yield serves as a leading indicator for mortgage rate movements.

When the yield rises, mortgage rates typically increase as well, making borrowing for real estate purchases more expensive. A falling yield typically leads to lower mortgage rates, reducing financing costs.

By tracking the 10-year treasury trend, real estate professionals can anticipate mortgage rate shifts and better time purchases or structure investments to maximize profits under prevailing financing conditions.

Risk premium

The risk premium is the extra return an investor wants for taking on more risk. In real estate, it's the difference between the cap rate and the risk-free rate, often shown by the 10-year treasury note.

For instance, if a property's cap rate is 7% and the 10-year treasury note rate is 3%, the risk premium would be 4% (7% - 3%). A higher risk premium means investors expect more returns to cover the risks they see in the investment.

Using the cap rate and interest rate to your advantage

Cap rates and interest rates are interrelated metrics that play a significant role in the real estate investment landscape. Their relationship influences real estate valuations, financing costs, and overall investment returns.

The association between these two is dynamic, shifting across market cycles like recovery, expansion, hyper-supply, and recession. It's important to monitor not just the rates themselves but also economic indicators like the 10-year treasury note and risk premiums that shape this relationship.

Cap rates and interest rates form a financial picture you can use to evaluate real estate opportunities. Leverage the information effectively, and you'll be poised to make investment decisions that generate sustainable wealth and achieve your financial goals in the years to come.

How do interest rates affect cap rates? FAQs

Is it better to buy at a higher cap rate?

Buying properties with higher cap rates is generally better, as they indicate potentially higher returns. However, higher cap rates could also signal more risk or issues with the property that you should consider.

Is a 7% cap rate good?

A 7% cap rate can be good, but it depends on factors like the type of property, its location, and the market situation. Usually, a higher cap rate means there's a chance for more return on investment, but it could also mean the property has more risk or isn't as desirable. A 7% cap rate is considered pretty attractive for many commercial real estate investors.

What is the cap rate 2% rule?

The cap rate 2% rule is a simple guide that some real estate investors follow to decide if a property is worth exploring. It says that the property's cap rate should be about 2% higher than the current mortgage rate. So, let's say mortgage rates are 5%, then the cap rate should be at least 7% for the investment to be potentially profitable.