The cap rate spread is the difference between market cap rates and interest rates, usually the 10-year Treasury rate. Since the 10-year Treasury rate represents the risk-free rate, the capitalization rate spread in essence reflects the risk premium property investors are requiring in order to invest in property. [You can see here summary of the latest mortgage rate forecast]
It has been empirically confirmed that there is a statistically significant positive relationship between market capitalization rates and interest rates (Sivitanidou and Sivitanides, 1999, and Sivitanides et al, 2001).1 In other words, when interest rates go up market cap rates go up too. The significant compression of capitalization rates over the period 2001-2007 has a lot to do with the historically low interest rates that have been prevailing during that period.
The explanation for the strong link between capitalization rates and interest rates is that property competes in the capital market with alternative investment vehicles (both risky and risk-free). So, for example, when the rates for 10-year Treasuries go down investors will tend to turn to alternative investment vehicles, such as corporate bonds, stocks, and property. With more capital flowing to property, and keeping the supply of property investments constant, investors are forced to bid up prices. Keeping a property’s Net Operating Income (NOI) constant, higher property price stranslate to lower capitalization rates. Hence, the positive relationship between the capitalization rate and the interest rate.
The interest rate, as represented for example by the 10-year Treasury rate, represents the risk-free rate of return in the capital market, as it is guaranteed by the US government. On the contrary, corporate bond rates do not reflect risk-free rates, since there is no guarantee that the companies issuing those bonds will be able to make the interest payments stipulated by the bond instruments.
lWithin this context, the difference between the capitalization rate and the interest rate reflects in theory the risk premium investors are requiring in order to own property investment vehicles. Based on this rationale, the cap rate spread, or the difference between the capitalization rate and the interest rate, should increase when the risk, or at least the perception of risk of property investments, increases.
Empirical studies have shown that besides interest rates, capitalization rates are affected by several other factors, such as factors that affect the appreciation potential and the risk profile of a property investment. See the article Capitalization Rate Influences for a more detailed discussion of the full spectrum of factors that drive movements in cap rates. Just to briefly mention them here, these factors include property market influences, relating to the strength and prospects of the local market, such as rent movements, vacancy rate, absorption rate, etc. and capital market influences including movements in interest rates, returns in alternative investment vehicles and overall uncertainty and volatility in financial markets.
Empirical studies have also shown that property investor behavior is myopic. In other words property investors tend to extrapolate recent market trends into the future. This means that when vacancy rates are increasing and rents are falling investors tend to extrapolate such trends into the future and consider property investments more risky. Thus, the cap rate spread should be increasing during such periods, assuming that interest rates remain constant. On the contrary, when the market is strong, vacancy rates are falling and rents are rising, the cap rate spread should be decreasing, as investors would consider property investments less risky