Commercial real estate is priced as a risk premium over the risk-free rate. The cap rate spread (cap rate minus the 10-year Treasury yield, or in Canada the Government of Canada bond yield) represents the market's compensation for accepting CRE's illiquidity, management complexity, and credit risk relative to a sovereign fixed-income benchmark.
When 10-year Treasury yields rise materially, cap rates must eventually follow or property values must fall to restore the spread to a level that clears the market. The word 'eventually' carries most of the analytical weight: the transmission is neither immediate nor mechanical, and the lag between rate moves and cap rate moves is itself a source of CRE risk.
The transmission mechanism runs through the debt market. Rising risk-free rates increase the mortgage constant (the annual debt service per dollar borrowed) which narrows the spread between a property's cap rate and its borrowing cost.
When the mortgage constant exceeds the cap rate, the deal is in negative leverage: every dollar borrowed actually dilutes the equity return rather than enhancing it. The 2022-2023 rate shock drove the 10-year Treasury from sub-1.5% to over 5%, compressing cap rate spreads in many gateway markets to near zero or outright negative territory.
Transaction volume collapsed accordingly, as sellers and buyers could not agree on a new market-clearing price.
Cap rates do not move immediately with interest rates because of what practitioners call transaction inertia. Closed deals reflect financing locked 60-120 days prior; those sales then become the comparables appraisers use to mark values.
Appraisal-based indices such as the NCREIF Property Index (NPI) compound this lag because quarterly valuations rely heavily on transaction evidence that may be several quarters stale. Seller psychology adds another friction layer; owners holding appreciated assets resist repricing unless forced by debt maturity, redemption pressure, or distress.
Publicly traded REITs, which reprice in real time, typically lead private market cap rate adjustments by 12-24 months.
Cap rate spread sensitivity is not uniform across asset classes. Long-duration NNN assets (bondable net leases with 15-20-year terms) behave much like fixed-income instruments: their value is highly sensitive to interest rate moves because buyers are underwriting a fixed income stream with no re-pricing optionality until expiration.
Short-duration assets such as multifamily (12-month leases) and industrial (mark-to-market opportunities every 3-5 years) retain meaningful re-pricing power, which partially offsets rate headwinds through NOI growth assumptions. Office faces the most complex spread calculus: rate headwinds compound structural demand headwinds, and neither resolves on a predictable timeline.