What’s the Connection Between Cap Rates and Interest Rates?

It’s not uncommon for a Commercial Real Estate (CRE) investor to view rising interest rates with a watchful eye. Industry-driven data often reflects a distinct correlation between rising rates and declining property values, but sometimes it’s best to look at the bigger picture, asserts a recent report from TIAA Global Real Assets Research.

Today, investors calculate capitalization (cap) rates to gauge CRE pricing; in essence, cap rates indicate the rate of return on a real estate investment property. The rate of return is calculated by comparing the property’s Net Operating Income (NOI) with a price-to-earnings ratio.

According to the report, historic data proves that rising interest rates do not necessarily play a major factor in total performance. Instead, property performance has remained resilient, despite rising rates. For investors, it’s best to consider how the property performs overall in conjunction with rising rates.

The NCREIF Property Index, which reflects cap rates and 10-year treasury yields since 1993. TIAA Global Real Assets Research argues that the cap rates and rising interest rates have a roughly similar relationship, but not close enough to draw clear conclusions about property performance.

The report went on to say, “more importantly, historical data show that changes in treasury yields do not necessarily result in changes in cap rates. Even assuming lags between interest rate and cap rate changes, analysis found no statistically significant relationship between the two variables.”

TIAA Global Real Assets Research states that interest rates and cap rates have a complex partnership and should not be considered equally when analyzing CRE market data. While admittedly, property performance is highly dependent on the economy and market environments, the ultimate impact of a fluctuating interest rate is almost impossible to predict.

Conventional wisdom in the industry is that when U.S. bond yields and interest rates move, cap rate movements will mirror this trajectory, indicating that the two variables are strongly correlated. However, cap rates and treasury yields historically have not exhibited a strong correlation, even when analyzing their trajectories dating back several decades,” read an outlook by accounting firm EY.

From the 1980s to today, history has shown several times in which cap rates and interest rates don’t align, and even sway in opposing directions, according to EY. In the end, factors including changes to supply and demand, transaction activity and economic trends all impact the trajectory of cap rates and real estate values.