Cap Rates and Interest Rates: How the Spread Sets Property Prices

Cap rates follow interest rates, with a lag and a spread. When borrowing costs rise, buyers need more income to carry the debt and pay less for the same NOI, so cap rates drift up. When borrowing costs fall, the reverse. The spread between the two is the market’s price for the risk and work of owning property instead of a bond.

That relationship sets property prices as much as rent does, and it is the reason the same building was worth more in 2021 than in 2023 without its income changing.

Why cap rates track interest rates

A buyer choosing between a rental property and a Treasury bond wants to be paid for the difference: illiquidity, management, vacancy, repairs and the chance the neighborhood turns. So cap rates sit above the risk-free rate by a spread that reflects those risks.

When the risk-free rate rises, the whole structure shifts up. A 4% cap rate that looked fine against a 1.5% Treasury looks thin against a 4.5% one. Buyers demand more yield, which means paying less for the same NOI.

Financing costs push the same direction more directly. A 30-year loan at 3.5% costs about 5.4% of the balance each year in payments. At 7.25% it costs about 8.2%. A property that carried its own loan at a 6% cap rate in 2021 loses money on every borrowed dollar at the same cap rate in 2024. Leveraged buyers either need a higher cap rate or a bigger down payment, and the ones who need a higher cap rate stop buying until prices adjust.

Why cap rates move less than rates

Between early 2022 and late 2023, 30-year mortgage rates rose roughly four points. Residential cap rates rose on the order of one point in most markets, with wide local variation. Three reasons the move was smaller:

Sellers do not have to sell. Owners with 3% mortgages held rather than accept lower prices, so transaction volume fell far more than prices did. Cap rates in thin markets adjust slowly.

Rents kept growing. NOI rose in most markets through 2022 and 2023, which lifted cap rates on existing prices without prices falling.

Spreads compressed. Buyers accepted a narrower gap between cap rates and Treasury yields than they had before, betting that rates would fall back. In some coastal markets the spread went to zero or negative in 2023.

The pattern is typical. Cap rates absorb rate moves partly through price, partly through rent growth, partly through spread compression, and over a period of one to three years rather than immediately.

The spread today

Historically, residential income property has traded at a cap rate two to four points above the 10-year Treasury yield. With the 10-year around 4 to 4.5% in 2025 and 2026, that would put fair cap rates at 6 to 8.5%. Many markets trade below that, which means either that buyers expect strong rent growth, that they expect rates to fall, or that property is expensive relative to bonds. Probably some of each.

A spread that narrow leaves less cushion. If rates stay where they are and rents flatten, cap rates have room to rise and values to fall. If rates drop, cap rates likely compress again and values rise. Buying at a thin spread is a bet on the second outcome.

What it means for a buyer now

Compare cap rate to the loan’s constant, not to the interest rate. At 7.25% over 30 years the constant is about 8.2%. A property below that cap rate has negative leverage: every borrowed dollar reduces the return on your cash. The cap rate vs cash on cash guide covers the mechanics. Most properties in most metros are below 8.2% today, which is why financed cash flow is hard to find.

Underwrite the exit cap rate higher than today’s. A property bought at a 6% cap rate and sold at 6.5% loses about 8% of value before rent growth. Modeling the sale at the purchase cap rate assumes rates fall, which is a forecast.

Value the refinance option honestly. If rates fall two points, a refinance flips negative leverage to positive and the deal works. If they do not, you own a property with thin or negative cash flow at the cap rate you paid. Price both outcomes.

Prefer markets where the cap rate already clears the constant. They exist, mostly in lower-cost regions. The cap rate pages show what an 8% or 9% cap rate requires in rent at each price point.

What it means for a seller

If you bought before 2022, the market cap rate is probably above your going-in cap rate, and the value gain from rent growth has been partly offset by cap rate expansion. Whether to sell depends on the spread between what a buyer will pay now and what you expect if rates fall. Neither is knowable, but the arithmetic is: from a 6% cap rate to 5%, the value of $18,270 of NOI rises from $304,500 to $365,400. From 6% to 7%, it falls to $261,000.

The one-line version

Cap rates sit a few points above interest rates and follow them up and down, slowly. When the gap between the cap rate and your loan’s annual cost is positive, borrowing helps. When it is negative, you are paying for growth you have not seen yet. The calculator shows the cap rate on your numbers; comparing it to your loan’s cost is the step that turns it into a decision.