What happens to capitalization rates when interest rates increase?

When interest rates increase, capitalization rates typically also rise. Capitalization rates represent the expected rate of return on an investment property, and they are influenced by the cost of borrowing money, which is directly tied to interest rates.

As interest rates rise, the cost of financing becomes more expensive for investors. In response, they are likely to demand higher returns on their investments to justify the increased cost. This results in an upward adjustment of capitalization rates. Essentially, if the market expects higher borrowing costs, the yield that investors look for to make an investment attractive also increases, leading to higher capitalization rates.

This relationship is fundamental in real estate investment analysis because a higher capitalization rate typically indicates a higher perceived risk or required return by investors. Meanwhile, lower capitalization rates are often seen in stable or lower-interest-rate environments where the costs of financing properties are less burdensome. Thus, the correct response accurately reflects the economic principles governing real estate investments in relation to changing interest rates.