The complex interaction between real estate cap rates and interest rates

Abstract

Low interest rates have played a key role in the recent decline in cap rates over the last three years. Falling interest rates have allowed real estate investors to pay a premium for assets by using leverage to enhance returns. With cap rates near historic lows, and short-term interest rates likely to increase as the US Federal Reserve gradually raises rates, investors are concerned about the effects of higher interest rates on asset values. It seems obvious that real estate cap rates and interest rates should be related. But the interaction between interest rates and real estate values is complicated. This paper looks at the recent trend in cap rates and uses duration, a concept used in the fixed-income market, to create a model for estimating the impact of higher interest rates on real estate values. Copyright © 2005 Henry Stewart Publications