What REALLY Drives Real Estate Cap Rates [& Why]

There are a lot of different factors that play into real estate cap rates, and with changes to this metric directly impacting property values, knowing how these factors come into play is extremely important.

So in this post, we’ll talk through two of the biggest drivers of cap rates in the commercial real estate market, and how interest rates end up playing into these.

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Understanding Cap Rates

Cap rates can be calculated by taking a property’s annual net operating income (or NOI) and dividing that by the property’s value. This essentially tells an investor what their going-in, unlevered NOI yield is projected to be on an investment before factoring in things like loan proceeds, loan payments, or major capital expenses.

This means that, assuming NOI values stay constant, property values decrease when cap rates expand (or rise), and property values increase when cap rates compress (or fall).

This makes the cap rate a major focus point when it comes to the health of the real estate market, and while there are many different factors that can influence these, two of the biggest things that shape cap rates in commercial real estate are:

1. Interest rates (and changes to these over time)
2. Demand for commercial real estate from the capital markets

Driver #1: Interest Rates

As a general rule of thumb, as interest rates fall, cap rates also tend to fall, and as interest rates rise, cap rates also tend to rise. This is primarily due to higher interest costs having a material impact on investor returns, all else being equal.

How This Works in Practice

To use an example, let’s say an investment firm is looking at a property with a $6 million going-in NOI, and they’d also be financing this acquisition with a 65% LTV loan at a 5.5% interest rate, amortizing over 30 years.

Let’s also say that NOI growth is expected to be 3% per year, and the property is assumed to be sold at a 6% cap rate after 10 years of ownership.

Based on all of this information, if this investment firm had an IRR target of 14% for this deal, they could reasonably offer $98 million for the property and hit their target return.

However, if everything stayed the same on the deal, but the interest rate dropped from 5.5% down to 4%, this investor could now raise their offer price up to $104 million and still hit their IRR target. This represents more than a 6% value increase over the original scenario.

Why This Matters at Scale

Since many commercial real estate investment firms (especially major institutions that deploy billions of dollars of capital into the real estate market) tend to advertise these return targets when raising capital from investors, movements in interest rates can cause huge, widespread changes in property pricing throughout the entire industry.

Driver #2: Investor Demand for Commercial Real Estate

On the demand side of the equation, this really comes down to the number of active capital allocators that are interested in investing in commercial real estate, which is heavily influenced by the perceived risk within this particular asset class.

When investor demand falls, cap rates typically rise, since there’s less price competition from buyers in the market. Alternatively, when investor demand spikes, cap rates can fall at a pretty rapid pace.

Competition from Other Investments

Investor demand can also be heavily influenced by other factors outside of real estate, including inflation expectations, GDP forecasts, and even the performance of other investment vehicles in the market.

If an investor can earn a higher rate of return while taking on a lower level of risk by investing in a different asset class, that investor will often shift away from commercial real estate. As a result, commercial real estate values will typically fall, since there are fewer bidders for the same number of properties listed for sale.

How To Learn More About Real Estate Investment Analysis

If you want to learn more about how cap rates play into the real estate investment analysis process, or you want to make sure you’re prepared for an Excel modeling exam that might be given to you when interviewing for jobs at commercial real estate firms, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.