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.
The clearest way to see the relationship is the cap-rate spread: the cap rate minus the yield on a long government bond (the 10-year U.S. Treasury, or the Government of Canada 10-year in Canada). That spread is the extra yield investors demand for owning real estate instead of a risk-free bond, compensation for illiquidity, credit and vacancy risk, and active management. Historically the spread has averaged a few hundred basis points, but it is not constant.
This is why cap rates move with interest rates but not in lock-step. When bond yields rise, the spread compresses first; if it compresses below the level investors require, either cap rates must rise (values fall) or NOI growth must justify the thinner spread. The 2022 to 2023 rate shock, which took the U.S. 10-year Treasury from below 1.5% in late 2021 to roughly 5% at its October 2023 peak, drove spreads in several gateway markets toward zero, and transaction volume fell sharply as buyers and sellers could not agree on a clearing price.
Interest rates reprice continuously, but private-market cap rates are inferred from closed sales, and those sales reflect financing locked 60 to 120 days earlier. The comparables an appraiser relies on are therefore already stale, and appraisal-based benchmarks such as the NCREIF Property Index compound the lag because quarterly valuations lean on that transaction evidence. Owners of appreciated assets also resist marking down until forced by a debt maturity, redemption pressure, or distress.
The practical result is a visible lead-lag structure. Publicly traded REITs, which reprice in real time, generally move 12 to 24 months ahead of reported private cap rates. And the sensitivity is uneven: a long-duration bondable net lease reprices almost entirely off interest rates, while a multifamily or industrial asset with frequent lease turnover can grow NOI into a higher-rate environment, partly offsetting the drag.
Cap rates tend to move in the same direction as interest rates because property is priced as a spread over the risk-free rate, but the relationship is partial and lagged rather than one-for-one. When bond yields rise, the cap-rate spread compresses first, and cap rates adjust later as the market reprices.
The cap rate spread is the cap rate minus the yield on a long government bond, typically the 10-year U.S. Treasury or the 10-year Government of Canada bond. It is the extra return investors require for owning real estate rather than a risk-free bond, compensating for illiquidity, credit and vacancy risk, and management.
Not immediately, and not one-for-one. Cap rates can lag interest rate increases by several quarters, and a strong-demand market may absorb higher rates through NOI growth or a thinner spread rather than higher cap rates. Over time, though, sustained higher risk-free rates put upward pressure on cap rates.
Because private-market cap rates are derived from closed sales, which reflect financing locked months earlier, and appraisal-based indices trail that already-stale evidence. Sellers also resist repricing until a debt maturity or distress forces it. Listed REITs, which reprice in real time, usually lead private cap rates by 12 to 24 months.
Negative leverage occurs when the cost of debt (the mortgage constant, or annual debt service per dollar borrowed) exceeds the property's cap rate. In that case adding debt lowers the equity return instead of raising it. Rising interest rates push deals toward negative leverage when cap rates have not yet adjusted upward.
Long-duration net-lease assets behave like bonds, so their values are very sensitive to interest rate moves and their spreads compress quickly. Short-lease assets such as multifamily and industrial can raise rents as leases roll, letting NOI growth partly offset higher rates, so their effective sensitivity to interest rates is lower.
Falling risk-free rates ease upward pressure on cap rates and can allow them to compress again, but the move is partial and lagged, not automatic. Lower borrowing costs restore positive leverage and can revive transaction volume, yet cap rates only follow if investors expect the lower-rate environment to persist and property fundamentals support it.