Real Estate · Multifamily
In December 1980, the U.S. Federal Reserve targeted interest rates at 19–20% — their highest ever — as part of Paul Volcker's historic efforts to combat the Great Inflation of the 1970s. Since then, U.S. interest rates trended downward for over 40 years, reaching historic lows in the early 2020s. By 2008, rates had dropped so low the Fed implemented quantitative easing for the first time in its history.
In January 2021, mortgage rates for 30-year fixed-rate loans hit an all-time low of 2.65%. However, year-over-year inflation jumped to 9.1% in June 2022 — the highest since 1981 — prompting the Fed to aggressively raise rates.
Capitalization rates ("cap rates") are determined by dividing a property's annual net operating income (NOI) by its current market value. Cap rates are positively correlated with interest rates — as rates rise, cap rates tend to follow. A cap rate has two primary components:
Risk-Free Rate: The 10-year Treasury Note rate, representing return on a zero-risk investment.
Risk Premium: The excess return compensating investors for taking on real estate risk over Treasuries.
A third component, anticipated NOI growth (g), may also apply. In multifamily housing — given short-term lease structures — rents can be adjusted with market conditions, meaning rising nominal rates can theoretically be offset by rising NOI.
| Scenario | Cap Rate | Cash Flow Multiple | Valuation Impact |
|---|---|---|---|
| 2022 Lows (Benchmark) | 3.25% | 30.8x | — |
| Current Rate – Low Spread | 2.97% | 33.7x | +9.4% |
| Current Rate – Avg Spread | 5.97% | 16.8x | –45.6% |
| Current Rate – High Spread | 7.97% | 12.5x | –59.2% |
| Normalized Rate – Avg Spread | 6.75% | 14.8x | –51.9% |
Real estate valuations are negatively correlated with interest rates. Rising interest rates increase borrowing costs — the majority of CRE deals are financed in part through debt. When it costs more to borrow, buyers cannot afford to pay as much, causing downward pressure on valuations.
Current real estate valuations are near all-time highs after peaking in June 2022. CoStar's Commercial Repeat Sales Index reported July 2022 prices 33.7% higher than pre-pandemic levels — themselves nearly twice mid-2000s housing bubble valuations. Multifamily has particularly outpaced other property types over the past decade, even as office and retail suffer from post-COVID structural changes.
Given the extreme nature of variables in the current inflationary environment, it would be hard to imagine a scenario in which real estate valuations do not fall 30–40% in the near future. Rising rates will compress returns even after rent increases, as interest expense absorbs the lion's share of improved cash flow.