Interview questions
How do rising interest rates affect cap rates and property values?
One of the most common technical questions in real estate private equity interviews, with a simple, effective way to answer it.
By the CRE Modelling team
“How would rising interest rates impact cap rates and property values?”
The interview question
Four parts, in this order, and the interviewer hears someone who understands the mechanism rather than the headline.
1. The relationship between interest rates and cap rates
- As interest rates rise, cap rates generally increase because investors demand higher returns on their investments.
- Higher cap rates mean the property is priced lower relative to its NOI, leading to a decrease in property value.
2. The impact on property values
- With higher cap rates, property values fall, since the valuation formula is inversely related to the cap rate.
- In a rising rate environment this might lead to a softening in the market or a correction in property values.
3. A practical example
If a property was trading at a 5% cap rate and interest rates rise by 100 basis points, investors might now require a 6% cap rate. On the same £1.0m of NOI:
Cap rate 5% to 6%, same NOIIllustrative figures, rounded.
| At 5.0% | At 6.0% | ||
|---|---|---|---|
| 1 | NOI | £1.00m | £1.00m |
| 2 | Value (NOI ÷ cap rate) | £20.0m | £16.7m |
| 3 | Change in value | –£3.3m, about a sixth (roughly 17%) |
One point on the cap rate takes about a sixth off the value. That is why a rate cycle reprices a whole market, not just the marginal deal.
4. The impact on leverage and financing
- As borrowing costs rise, it becomes harder to secure financing on favourable terms.
- The debt service coverage ratio (DSCR) might decline, leading to fewer deals getting financed.
This is the kind of technical knowledge you need to show in your interviews.