How Rising Interest Rates Affect Cap Rates

# How Rising Interest Rates Affect Cap Rates One of the most important relationships in real estate investing is between interest rates and cap rates. Understanding this connection will save you from overpaying during rate cycles. ## The Basic Relationship Cap rates and interest rates tend to move together over time. When interest rates rise, investors demand higher returns (higher cap rates) on real estate to compensate for: 1. Higher cost of debt (debt service eats more of NOI) 2. Competition from "risk-free" rates (Treasuries become more attractive) 3. Reduced purchasing power (same cash flow, higher financing costs) **The historical spread:** Real estate cap rates have historically traded 150–250 basis points above the 10-year Treasury yield. When that spread compresses (as it did in 2020–2022), prices are stretched. ## The Math: Why Cap Rates Must Rise With Rates Let's run an example. Property with $60,000 NOI: **When rates are at 3% (10-yr Treasury):** - Fair cap rate: ~5% (300 bps spread) - Implied value: $1,200,000 - With 70% LTV at 4.5% mortgage rate, annual debt service: $45,540 - Cash-on-cash on $360k equity: 4.0% **When rates rise to 5% (10-yr Treasury):** - Fair cap rate: ~7% (200 bps spread) - Implied value: $857,000 (-29% decline) - With 70% LTV at 7.0% mortgage rate, annual debt service: $47,700 - Cash-on-cash on $257k equity: 4.8% The property's NOI didn't change. The rate shift alone caused a ~29% decline in fair value. ## What Happens When Rates Rise Faster Than Cap Rates From 2022–2024, rates rose sharply but cap rates lagged. This created negative leverage — where your debt costs exceed your property's yield. In those conditions: - Buyers demand seller financing or price cuts - Transaction volume falls (sellers won't cut, buyers can't pencil) - Experienced investors wait for cap rates to normalize In 2025–2026, we saw delayed cap rate expansion as sellers finally adjusted expectations. ## How to Use This in Your Underwriting **Run a cap rate sensitivity analysis.** When analyzing a deal, model cap rates at +50, +100, and +150 basis points from today's market. How does your exit valuation change? **Calculate positive leverage.** Your cap rate should exceed your all-in mortgage rate for positive leverage. If your cap rate is 6% and mortgage rate is 7%, you're in negative leverage territory — equity returns are diluted by debt. **Stress test at higher rates.** For 5-year holds, assume your refinance rate will be 50–100 bps higher than today. Model your DSCR at that rate before you buy. *Use our [Cap Rate Calculator](/tools) to run these analyses on any property.*