Interest rates and cap rates are both measures of the cost of capital, but they serve different purposes and are used in different contexts. Many people overlook the dramatic effect of interest rates on cap rates. Understanding their relationship is integral to analyzing any potential real estate investment.
Interest rates are the cost of borrowing money, usually expressed as a percentage of the loan amount. They are typically used to determine the cost of borrowing money for things like mortgages, car loans, and credit card debt.
A Cap Rate is a ratio that helps us to determine the rate of return on a piece of real estate. It is the ratio of NOI to the total value of the property. The cap rate is usually presented as a percent. Investors use Cap Rates to compare the profitability of similar investments quickly. The Cap Rate is calculated like this:
For example, if a rental property’s yearly income is about $60,000 and the total value of the property is $1 million, then the property’s Capitalization Rate is 6%.
A high cap rate indicates a higher potential return on investment, while a low cap rate suggests a lower potential return.
But what effect does the interest rate have on the capitalization rate? Well, a drop in the interest rate makes it much cheaper for investors to get a loan, resulting in a huge increase in the market value of the building. People often associate this rise in value with inflation, but it is actually caused by a decrease in interest rates.
So, a small decrease in the interest rate can cause a dramatic decrease in the capitalization rate.
Conversely, when interest rates are high, it can make borrowing more expensive, which can lead to lower demand for real estate and push cap rates up.
However, it’s important to note that many other factors can influence cap rates, including the location and quality of the property, the strength of the local real estate market, and the overall state of the economy.
Interest rates and cap rates serve different purposes and are used in different contexts. Understanding the relationship between these two factors can be helpful for anyone considering an investment in real estate.
Sources: Chen, James. “Capitalization Rate: Cap Rate Defined With Formula and Examples.” Investopedia. April 19, 2022. www.investopedia.com/terms/c/capitalizationrate.asp. Tweed, Robert R. “Interest Rates and Cap Rates.” Tweed Financial. Tweed Financial Services, Inc, Accessed December 21, 2022. www.tweedfinancial.com/files/15468/ Interest%20Rates%20and%20Cap%20Rates%20032118.pdf.