Cap Rates and Interest Rates in U.S. Commercial Real Estate: A Data Note

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Introduction

The relationship between capitalization rates (“cap rates”) and interest rates is a cornerstone of commercial real estate (CRE) finance. Lenders and investors closely watch cap rates – the ratio of a property’s net operating income to its value – alongside benchmarks like Treasury yields or mortgage rates. In theory, higher interest rates should lead to higher cap rates (lower property values), while lower rates compress cap rates and boost values. However, empirical data shows this relationship is nuanced, influenced by inflation, risk premia, and market cycles. This data-driven note examines the spread between cap rates and interest rates in the U.S. CRE market, breaking down what that spread represents (term premia, credit risk, illiquidity, and other risk factors) and analyzing what truly drives cap rate movements. We focus on the post-Global Financial Crisis (GFC) and post-COVID eras, highlighting implications for lenders in today’s environment of rising rates and repricing assets.

The Cap Rate–Interest Rate Spread

A common gauge in CRE investing is the spread between cap rates and a risk-free interest rate (often the 10-year U.S. Treasury yield). This spread represents the extra return investors demand from real estate over a “safe” bond yield, compensating for additional risks and illiquidity. Historically, the average spread has been on the order of 200–300 basis points (bps), albeit far from constant. For example, from the early 1990s through 2015, the spread averaged roughly 2.5%. Over the past 25 years, the 10-year Treasury yield fell from ~6% in the late 1990s to under 1% in 2020, while average CRE cap rates fell from ~8% to under 4%. The cap rate–10yr Treasury spread during that quarter-century averaged about 2.4%, but ranged widely from as low as 0% (virtually no risk premium) to as high as 4%. In other words, sometimes real estate yields barely exceeded Treasurys, and at other times they offered a hefty premium.

Analysts often interpret a high cap rate spread as indicating that real estate is relatively undervalued or offers a larger risk cushion, whereas a low spread suggests rich pricing and vulnerability to cap rate expansion (and price declines) if conditions change. For example, in 2007 cap rates on institutional properties averaged around 5.0% when the 10-year Treasury was ~4.7%, a spread near zero – foreshadowing a peak in property values. By 2009–2010, amid the GFC fallout, cap rates spiked to ~7% while 10-year yields fell below 3%, pushing the spread to an unprecedented ~4.4% as investors demanded much higher returns for distressed and illiquid assets. The spread then settled back: in 2016 it averaged ~2.75% (slightly above the 25-year norm), before tightening again in the late-2010s. Most recently, ultra-low interest rates in 2020–21 drove cap rates to historic lows (around 4% or less). When the 10-year yield was 1–2% in 2021, the spread hovered around 200–300 bps; but as interest rates surged in 2022, the spread compressed sharply. By early 2022, cap rates ~4.1% versus a 2.4% 10-year yield left only a 170 bp spread, at the bottom of its typical range. As the 10-year yield jumped above 3.5% later in 2022, cap rates initially lagged – compressing the spread below 100 bps, a historically thin cushion in a low-inflation setting. This extreme spread tightening signaled that property values had not yet adjusted to the new rate environment, raising red flags for lenders.

Decomposin the Cap Rate Spread: Risk Premia and Term Structure

What exactly does the cap rate spread over Treasurys represent? In essence, it is a risk premium – the extra yield for holding a risky, illiquid asset versus a safe liquid bond. Several components underlie this spread:

• Term Premia: Real estate is a long-duration asset, often with income streams and holding periods spanning a decade or more. Investors therefore require compensation for interest rate uncertainty over time. The 10-year Treasury yield itself includes a term premium (the excess yield above expected short-term rates), historically on the order of 1% or so (though it varies). If one were to compare cap rates to a short-term rate like the Fed Funds, a large part of the gap would simply reflect the normal yield curve/term premium for committing capital long term. Using the 10-year yield as the benchmark already embeds this term factor.

• Inflation Expectations: A portion of nominal bond yields is an inflation premium – the return needed to maintain purchasing power. Over 1991–2016, for example, U.S. inflation averaged ~2.3%, contributing that much to the 10-year Treasury’s average yield (~4.5%). Real estate cap rates, by contrast, are often viewed in real terms since property incomes can grow with inflation. If investors expect higher future inflation (and thus higher rent growth), they may accept a lower current cap rate. In fact, comparing cap rates to nominal Treasurys is an “apples-to-oranges” exercise in that it pits an inflation premium (in the bond yield) against risk premia (in the cap rate). This is why analysts sometimes adjust for inflation – for instance, comparing cap rates to inflation-adjusted (real) bond yields.

• Credit Risk Premium: Commercial properties carry income uncertainty and potential for value impairment (tenants might default or vacate, cash flows can decline, etc.), akin to credit risk on a bond. Thus, part of the cap rate spread reflects a default or credit risk premium. In concept, one can liken an all-equity property investment to a BBB/Baa-rated corporate bond – both have higher yields than Treasurys to compensate for the chance of income disruption or loss. Indeed, over the past few decades the inflation-adjusted yield on Baa corporate bonds averaged about 2.4%, in line with the baseline risk premium investors demanded on CRE. This suggests roughly 2–3% of cap rate (in real terms) is attributable to the fundamental credit risk of property cash flows (varying by tenant quality, lease terms, etc.).

• Illiquidity Premium: Real estate is notably illiquid – properties cannot be bought or sold as quickly or cheaply as financial securities. Investors require additional yield to compensate for this illiquidity. Estimates of the illiquidity premium in private CRE are on the order of 1–2%. Unlike publicly traded bonds, which can be sold readily, a building might take months to transact and incur substantial costs, so investors build in extra return. This illiquidity premium is unique to private real estate and sits on top of the credit risk premium.

• Other Risk Premia: Additional factors can widen the spread. These include market risk premium (overall higher required returns for equity-like assets), asset-specific risk (e.g. older properties or those in volatile markets might have higher cap rates), and structural risks (like depreciation or capex needs, which reduce effective income). Real estate also often has idiosyncratic risks – for instance, regulatory and tax changes or climate risk – that might not apply to bonds and thus demand some yield cushion.

Putting it together, a simplified decomposition might express a nominal cap rate as:

Cap Rate≈Real risk-free rate+Expected inflation+Risk premia (credit + illiquidity + others)−Expected NOI growth

The last term (expected growth) is important – if investors expect net operating income to grow, they will pay more today (accept a lower cap rate) for the same current NOI. This functions like a negative component in the cap rate. For example, in periods of high expected rent growth, cap rates can stay low even if interest rates are high, because future income growth is “baked in.” In contrast, if income growth prospects are poor or negative, cap rates must be higher to entice investment. This growth factor often explains why cap rates don’t move one-for-one with interest rates. When interest rates rise due to higher inflation expectations, investors may partially offset it with higher anticipated NOI growth, dampening the impact on cap rates. On the other hand, if rates rise due to higher real yields or risk aversion (with no increase in growth outlook), cap rates tend to rise more sharply.

In sum, the cap rate spread over Treasurys primarily reflects compensation for risk and illiquidity – historically on the order of 3–5% in total (e.g. ~2–3% credit risk + 1–2% illiquidity) in normal times. Meanwhile, Treasurys compensate for time value and inflation. It follows that comparing a cap rate to a nominal 10-year yield is essentially comparing “risk premium vs. inflation premium”. Analysts must adjust for that when judging if spreads are fair. For a more apples-to-apples comparison, one can line up real estate’s risk-driven yield against an inflation-adjusted bond yield. Research shows that, as expected, cap rates generally sit above inflation-adjusted BBB bond yields (to account for extra illiquidity), except in unusual periods.

Drivers of Cap Rates: Real vs. Nominal Rates, Credit Spreads, and Fed Signals

Do cap rates respond more to nominal interest rate moves or underlying components like real rates and credit spreads? A growing body of evidence suggests that real interest rates and credit conditions are the true key drivers of cap rates, rather than nominal rates alone. Nominal rates matter, but mainly to the extent they represent changes in real yields or risk sentiment.

Impact of Real vs. Nominal Rates: Because real estate can hedge inflation (rents often rise with prices), cap rates are more sensitive to real interest rates (inflation-adjusted rates) than to headline nominal rates. If interest rates rise purely due to higher inflation expectations (with real rates flat), property values may hold up relatively well – investors anticipate higher future NOI, so they don’t require as much of a cap rate increase. However, if real rates rise (tighter monetary policy, higher real yield to attract capital) with little change in inflation expectations, that directly increases borrowing costs and required returns, putting upward pressure on cap rates. As one analysis noted, real estate values suffer more when cap rates rise due to higher real rates rather than inflation. During the 1970s–1980s high-inflation era, cap rates did not spike as much as nominal bond yields; in fact, the cap rate spread turned negative (cap rates fell below 10-year Treasury yields) because investors were pricing in strong future rent growth during inflation. That counterintuitive scenario underscores how inflation can benefit property income. By contrast, in low-inflation regimes, any rise in nominal yields typically reflects higher real rates, which can lift cap rates unless offset by other factors.

Role of Credit Spreads and Risk Appetite: Credit market conditions – reflected in corporate bond yields and lending spreads – strongly influence cap rates. When corporate credit spreads widen (indicating higher risk aversion or default risk), real estate investors likewise demand higher returns, pushing cap rates up. A recent analysis by MetLife Investment Management found that a simple two-variable model using the Moody’s Baa corporate bond yield and the 2-year Treasury rate explains a significant portion of cap rate movements. In that model, a 100 bps increase in the Baa corporate yield (which incorporates both the risk-free base rate and corporate credit risk) translates to roughly a 92 bps increase in transaction cap rates. In other words, cap rates move almost one-for-one with changes in the cost of capital and credit risk sentiment captured by Baa yields. This makes intuitive sense: if investors can get higher yields in corporate bonds or if debt financing for real estate becomes more expensive, they will require a higher cap rate (lower property price) to invest in CRE.

Crucially, the same model showed that after controlling for credit yields, the 2-year Treasury yield (a proxy for near-term Fed policy and inflation outlook) has an inverse relationship with cap rates. Historically, a rising 2-year yield (often signaling rising inflation expectations or tighter Fed policy) has been associated with lower cap rates, once credit conditions are accounted for. This seemingly counterintuitive result aligns with the idea that when inflation expectations rise, investors foresee higher future NOI growth, which bolsters property values despite higher current rates. Essentially, inflation-driven rate rises can compress the cap rate spread, whereas risk-driven or “real” rate rises expand it.

Other research and industry observations echo these points. A 2016 TIAA study found a moderate positive correlation (~0.7) between cap rates and 10-year Treasury yields over 1992–2015, but with plenty of divergences. Morgan Stanley analysts noted that the rolling 5-year correlation between cap rates and Treasury yields swung from strongly positive to negative at different times from the 1980s to 2013. In fact, in five of eight notable rising-rate periods they analyzed, cap rates moved in the opposite direction (down when interest rates rose, or vice versa). Why? Because factors like lagged appraisal values, capital flows, and credit availability can dominate in the short run. Private-market cap rates often adjust with a lag, especially when transaction volumes are low, since appraisals rely on stale comparables. Meanwhile, abundant capital and easy credit can keep cap rates low even amid rate hikes (as seen in 2021–early 2022), whereas a credit crunch can force cap rates up even if base rates are stable.

Forward Guidance and Expectations: Forward guidance by the Federal Reserve – signaling the expected path of future rates – also plays a role through shaping the yield curve and investor expectations. If the Fed convinces markets that rate rises are temporary or will be reversed (as in an inverted yield curve scenario), equity investors in real estate might “look through” current high rates and keep cap rates lower in anticipation of future relief. This occurred in 2022–2023: even as current interest costs exceeded cap rates in some cases (negative leverage), some buyers justified low cap rates by betting on rates falling in the near future. Such behavior essentially treats forward guidance and yield curve signals as part of the pricing: an inverted yield curve (short rates > long rates) often implies the market expects rate cuts ahead, which can temper the rise in cap rates. However, this can be risky if those expectations are wrong. As Verus Investments warned in late 2023, real estate pricing at cap rates below borrowing costs was predicated on an “unrealistically rosy” scenario of a return to near-zero interest rates, and valuations had not adjusted enough. Lenders need to be wary of such gaps between market pricing and current debt fundamentals, as they signal vulnerability if the hoped-for rate declines or income growth do not materialize.

In summary, cap rates co-move most closely with the broader cost of capital and risk environment. Nominal interest rates matter, but primarily via two channels: (1) the risk-free real rate component and credit spreads (which raise or lower the opportunity cost of capital for CRE), and (2) inflation expectations (which can offset some interest rate impact through higher expected NOI growth). Cap rates are less mechanically tied to nominal Treasurys than a simplistic view would suggest. Instead, they are set in a equilibrium balancing yields on other assets, financing costs, and growth prospects. This means that understanding cap rate movements – especially for lenders – requires parsing why interest rates are changing (inflation vs. real rates, expansion vs. risk-off episode) more than just how much they are changing.

Stability of the Spread Across Market Cycles

The relationship between cap rates and interest rates has not been stable over time; it has shifted across different market cycles. For context, consider a few distinct periods in recent U.S. CRE history:

• High-Inflation 1980s: In the late 1970s and early 1980s, inflation and Treasury yields soared into the teens. Property incomes and values eventually responded to inflation (with rents and replacement costs escalating). During this regime, cap rates did not keep pace with spiking nominal rates. In fact, according to Crow Holdings data, the average cap rate spread was negative – on the order of -280 bps in the 1980s. Essentially, cap rates were lower than the 10-year Treasury yield because investors were banking on high inflation to boost future cash flows (accepting lower current yields). Of course, real (inflation-adjusted) interest rates were not as high as nominal ones, and by comparing cap rates to real yields one would find a more sensible positive spread. The 1980s taught investors that nominal comparisons can be misleading in inflationary times.

• 1990s–Mid-2000s: As inflation came under control in the 1990s, a more “normal” spread reasserted itself. From the early 1990s through mid-2000s, with moderate inflation (~2–3%) and generally declining interest rates, cap rates gradually compressed from high single digits toward the 6–7% range, while 10-year Treasurys hovered in the 4–6% range. The cap rate spread averaged roughly 250–300 bps in this span. It wasn’t a constant relationship – cap rates lagged and led at times – but over a full cycle one could discern a typical risk premium. The mid-2000s boom saw this premium shrink dramatically: by 2005–2007, cap rate spreads fell toward historic lows. For instance, in 2007 the NCREIF cap rate was ~5.0% vs. a 10-year yield of ~4.7%, just a ~0.3% spread. This was a period of plentiful debt, high investor risk appetite, and expectations of rent growth, all of which drove prices up and yields down. Lenders at that time were lending on thin cushions – small changes in interest rates or risk sentiment could (and did) cause outsized valuation impacts.

• Global Financial Crisis (2008–2009): The low spreads of the boom were abruptly reversed when the credit bubble burst. As mentioned, cap rates blew out to ~8% in 2009 for many property types, even as Treasury yields plummeted amid a flight to safety. This pushed the spread to 400+ bps in 2009–2010, an all-time high in the modern era. Essentially, property values collapsed faster than interest rates fell, reflecting a huge repricing of risk and illiquidity. Lenders from that period remember that even as the Fed cut rates to zero, real estate debt became more expensive (wider credit spreads) or unavailable, contributing to sharply higher cap rates. By 2010, opportunities for investors were attractive – the spread of ~4% was well above the ~2.5% long-term average, suggesting future cap rate compression (and price recovery) potential. Indeed, as the economy stabilized, cap rates started to inch down.

• Post-GFC Low-Rate Era (2010s): The 2010–2019 period saw persistently low interest rates (the 10-year averaged ~2.0–3.0% for much of the decade) and gradually recovering CRE fundamentals. Cap rates steadily compressed from the high single digits of 2009 toward the low-to-mid 5% range by the late 2010s. Importantly, the cap rate spread remained in a moderate band, generally 2–3%, through most of this cycle. For example, in 2016 the spread was ~2.75%, slightly above the 25-year average of 2.48%. Then, as interest rates ticked up in 2017–2018 (10-year yields rose from ~1.5% to ~3% at peak), cap rates in core property sectors rose only marginally, compressing the spread back below the long-run average by 2017. This implied that by 2017–2018, CRE pricing was full by historical standards – arguably overvalued relative to interest rates. Yet the spread measure alone can be misleading if it doesn’t account for inflation and growth. The late 2010s were characterized by low inflation and high competition for real estate assets, which kept risk premia thin. Banks and other lenders saw fierce competition as borrowers could justify aggressive pricing with cheap debt and optimistic pro formas.

• Post-COVID Whiplash (2020–2023): The COVID-19 crisis in 2020 initially froze transaction markets, but the massive monetary easing that followed created an environment of rock-bottom interest rates and abundant liquidity. By late 2020 and 2021, the 10-year Treasury fell under 1%, and debt costs for prime property were extremely low. Investors responded by bidding up CRE values to record highs, compressing cap rates to record lows. According to NCREIF, average cap rates on institutional-quality properties dipped below 4% for the first time by 2021. In some hot sectors like multifamily and industrial, cap rates in top markets were in the low-3% range – remarkably low yields for private real estate. This meant that by 2021 the spread over Treasurys, which were ~1.5% at the time, was perhaps ~200–250 bps (depending on the sector) – not the lowest ever, but certainly on the tighter side of history. Then came the interest rate shock of 2022–2023. The Federal Reserve’s fight against inflation drove the Fed Funds rate from effectively 0% in early 2022 to over 5% by 2023, and the 10-year Treasury yield from ~1.5% to ~3.9% by Q1 2023. Normally, one would expect cap rates to jump in tandem. But initially, private cap rates barely moved – in fact, they continued to edge down into mid-2022, reaching a low around 3.8% by Q3 2022 despite rising rates. This lag can be attributed to inertia in appraisals and sellers’ reluctance to lower prices when few transactions were occurring. The result was that by late 2022, cap rate spreads virtually vanished – for a brief period, cap rates and benchmark yields were roughly equal, and in some cases debt costs exceeded going-in yields.

  
  

  Such an unstable situation could not last, and indeed by 2023 cap rates finally began to climb. Private-market cap rates had risen to roughly 4.2% by Q1 2023 (NCREIF average for core properties) from their trough, a ~40 bps increase. Still, this was a very tepid move relative to the 250+ bps jump in interest rates, leaving a razor-thin spread of only ~30–50 bps at the start of 2023. By late 2023, as more transactions reset values, cap rates moved closer to equilibrium. Market estimates put average cap rates in the mid-5% range by Q4 2023 (varying by sector: e.g. ~5.2% industrial, 5.3% multifamily, 6.4% office/retail). With the 10-year Treasury oscillating around 4.0–4.5% in late 2023, the implied spread had normalized back to around 1–2% for many property types. Even so, that spread remained below historical averages, especially considering the higher inflation and uncertainty post-COVID. Notably, not all sectors behaved uniformly: Industrial cap rates stayed lowest (high investor demand due to e-commerce growth) and only rose modestly, while Office cap rates blew out significantly in the public markets (REIT-implied office yields reached ~10% by 2023) due to severe post-COVID occupancy challenges. Private office cap rates also increased, though less dramatically (from ~4.6% to ~5.1% over 2022), suggesting further re-pricing was likely. This divergence by property type reflects how asset-specific risk premia (e.g. secular demand shifts, lease durability) can cause spreads to widen more in some segments than others.

Through these cycles, one lesson is clear: the cap rate vs. interest rate spread is not static. It compresses and expands with capital market cycles and investor sentiment. Periods of easy money and strong capital flows (1990s, mid-2000s, 2015–2019, 2021) saw narrow spreads, meaning valuations were rich relative to bonds. Periods of stress or illiquidity (early 1990s, 2009–2010, 2022–2023 transition) saw wide spreads as real estate yields overshot to compensate for risk. For lenders, this means historical spread averages are a guidepost, not a rule. Underpricing of risk can persist for a time, but eventually reverts (often abruptly). Conversely, wide spreads may present opportunities but also signal distress.

Implications for Lenders and Investors in CRE Finance

For lenders, the interplay of cap rates and interest rates is directly tied to loan risk and asset valuation. A few key implications and considerations emerge from the data:

• Valuation Buffer and Credit Risk: The cap rate spread can be viewed as a valuation buffer. A healthy positive spread means a property’s income yield comfortably exceeds the risk-free rate, implying the asset has room to absorb interest rate increases or income shortfalls before debt coverage is jeopardized. For example, a 300 bps spread historically provided a cushion such that even if Treasury yields rose 100 bps, there was still extra yield to cover financing costs. When spreads compress to extreme lows, as in 2007 or 2021, the margin for error disappears – property values are priced for perfection. Lenders should be cautious in low-spread environments, as even minor rate upticks or a drift upward in required returns can push debt service coverage ratios (DSCRs) to uncomfortably low levels. Indeed, NAIOP’s analysis noted that the sub-1.5% cap rate spreads seen at times have often preceded periods of weaker property returns, essentially serving as a warning sign.

• Interest Rate Shocks and Repricing: Rapid increases in interest rates (like 2022’s cycle) can lead to a valuation lag in private CRE markets. Lenders might find that loan-to-value (LTV) ratios on existing loans blow out not because cash flows dropped, but because market cap rates rose (values fell) to restore a proper spread. Portfolio reappraisals and stress tests should account for the potential “catch-up” of cap rates to a new rate regime. The recent cycle illustrates this: private appraisals were slow to mark down values in 2022 even as public markets signaled a necessary 100–200 bps upward move in cap rates. Lenders refinancing loans now may face lower valuations and higher cap rates than anticipated a couple of years ago, affecting collateral coverage.

• Negative Leverage and Deal Feasibility: Perhaps the most striking development post-COVID was the occurrence of negative leverage – situations where the cost of debt (interest rate on loans) exceeded the property’s cap rate (initial yield). By 2022–2023, for many high-quality multifamily and industrial acquisitions, cap rates in the low-4% range were being financed with debt at 5–7% interest. When borrowing costs are higher than property yields, debt actually drags returns down (levered yields < unlevered yields), making deals pencil only if one assumes significant future rent growth or a decline in interest rates. This is a precarious position for lenders: it means DSCRs are thin from day one and any hiccup in income or increase in rates can lead to coverage shortfalls. As one investment manager described in 2023, it was a “bizarre deal environment” where equity buyers were accepting returns lower than the debt yields ahead of them in the capital stack. Such mispricing is unsustainable long-term. Lenders have understandably tightened underwriting in response – requiring more equity, higher DSCRs, or simply abstaining from loans where the going-in cap rate doesn’t exceed the interest rate by a safe margin. Until either asset prices fall (raising cap rates) or interest rates fall, transaction volume tends to stall in this scenario, as has been observed with 2023’s drop in CRE sales activity (down ~30% year-over-year).

• Decomposing Risk for Underwriting: Lenders evaluating a loan typically set an interest rate spread over Treasurys based on credit risk and term. Interestingly, the same components apply to equity investors via the cap rate. Lenders can thus cross-check if the equity side is pricing risk appropriately. For instance, if the loan spread implies a certain credit risk, and there’s an illiquidity premium observable in private equity markets, is the total cap rate in line with those risks plus a reasonable inflation expectation? If not – say, cap rates are lower than what those risk premia would suggest – it may indicate an overheated market or optimistic growth assumptions. By breaking the cap rate into “risk-free + risk premium – growth”, lenders and investors can better gauge when pricing is out of whack. The NAIOP framework of comparing cap rates to inflation-adjusted Baa bond yields is one practical approach to judge fairness. When property yields dip below inflation-adjusted corporate yields (as happened in certain periods), it suggests either an expectation of extraordinary NOI growth or an underestimation of risk – red flags for prudent financing.

• Forward Outlook – Flexibility is Key: Given that the Federal Reserve’s policy and economic conditions can change rapidly, lenders should build in rate flexibility and not rely on static spread relationships. The current environment (as of 2024–2025) features higher-for-longer interest rates but also easing inflation. Fed projections imply real rates may eventually settle around 1–2% in coming years. If inflation continues to recede, the risk is that real rates remain high, which would keep upward pressure on cap rates (wider spreads needed). Conversely, if the economy softens and the Fed pivots to cuts, the 10-year yield could fall, potentially allowing cap rates to compress again – but only if credit conditions and risk appetite recover. Lenders should stress-test loans for both scenarios: one where cap rates increase further (e.g. if real rates stay elevated or risk premia widen due to recession), and one where cap rates decrease or stabilize (if interest rates fall or liquidity improves). In either case, focusing on the underlying drivers – term, credit, illiquidity, growth – will help in structuring covenants and reserves to mitigate risk. For instance, in a high real-rate scenario, requiring more equity (lower LTV) and higher debt yields might be prudent. In a falling-rate scenario, strong prepayment/yield maintenance provisions may be important if loans could refinance into cheaper money.

Conclusion

In U.S. commercial real estate, cap rates and interest rates have a complex but critical relationship. They are linked by the fundamental principle of opportunity cost – money will flow to whichever offers a better risk-adjusted return. Yet the connection is not a simple lockstep; it is mediated by inflation, risk premia, and market sentiment. Decomposing the cap rate spread reveals that it is largely a risk compensation (for credit risk, illiquidity, etc.), which must be weighed against the inflation component of interest rates. Historical data show that the cap rate–interest rate spread has varied from deeply negative in high-inflation times to extremely wide in credit crises, defying any one-size rule. In the post-GFC low-rate era, spreads seemed range-bound around 2–3%, but the post-COVID upheaval reminded us that rapid shifts in monetary policy can destabilize that equilibrium, at least temporarily.

For lenders and CRE investors, the takeaway is to remain data-driven and vigilant. Rather than assuming a fixed spread, one must constantly ask: What is driving interest rates today? What is the market pricing in via cap rates? If cap rates are not keeping pace with a deteriorating credit environment, risk is building. If cap rates overshoot relative to a benign outlook, opportunities may be emerging. In the current cycle, understanding term premia, credit spreads, and forward guidance is essential – cap rates will respond differently to a rise in real yields than to a rise in inflation expectations or a liquidity-driven credit spread change.

Ultimately, prudent CRE lending and investing require balancing the yield (cap rate) against the cost of capital (interest rates) with a keen eye on the spread. The spread is where the risk lives. As the recent volatility has shown, cap rate spreads can compress to razor-thin levels (sounding an alarm) or widen dramatically (signaling stress and potential value). By deconstructing that spread into its components and watching its behavior across cycles, lenders can better navigate loan decisions and portfolio risks. In a world where interest rates and markets are ever-changing, such an analytical approach to cap rates is invaluable for making informed, resilient investment decisions in commercial real estate.

October 20, 2025, by a collective authors of MMCG Invest, LLC, real estate feasibility study consultants.

Sources: 

• Federal Reserve Economic Data;

• NCREIF Property Index and Trends reports;

• Green Street Advisors;

• Moody’s Analytics/Real Capital Analytics;

• CFA Institute & TIAA Global Asset Mgmt.

• NAIOP (Mark J. Eppli, 2017);

• Morgan Stanley (Paul Mouchakkaa, 2014);

• Verus Investments (2023);

• MetLife Investment Management (2025);

• CBRE Research (2024);

• Crow Holdings/Folsom Institute (2022);