Interest Rate

An interest rate is the yearly price of borrowed money, expressed as a percent of what is owed. Cap rates are calculated without financing, but interest rates still shape them: they set what buyers can afford to pay for a given NOI and what alternative investments yield.

When mortgage rates rise, a property at a fixed cap rate produces less cash flow for a financed buyer. Buyers respond by offering less, which pushes cap rates up. When rates fall the reverse tends to happen. The relationship is loose and slow, and cap rates often lag rate changes by months.

The direct link is the mortgage constant. If the loan's annual payment as a percent of the balance is above the cap rate, borrowing lowers the investor's return. At 7.25% over 30 years the constant is about 8.19%, well above the example property's 5.78%.