Not investment advice. Educational reading. See Disclaimer.
L.11 · INTERMEDIATE · 3 MIN
Cap Rate Decomposition (Yield + Growth + Risk)
Cap rates feel like a real-estate-specific number — yield divided by value, set by local market conditions. But the cap rate is actually tightly linked to the broader capital markets through a simple algebraic identity. Decomposing the cap rate into its components — risk-free yield, risk premium, and expected NOI growth — gives investors the bridge between real estate underwriting and the broader rate environment. Once you can decompose a cap rate, you can read what the market is implying about growth and risk, and you can spot when current pricing requires assumptions that may not hold.
Cap Rate ≈ Risk-Free Yield + Risk Premium − Expected NOI Growth
§ 02
The three pieces move independently and can swap relative weights. Risk-free yield is set by the Treasury market. Risk premium is set by investor demand for real estate vs. other risk assets. Expected NOI growth is set by sector fundamentals (e-commerce drives industrial growth, remote work depresses office growth, etc.).
§ 03
Environment
What happens to cap rates
What it means for property values
Falling rates, stable growth
Cap rates compress (lower)
Property values rise even at stable NOI
Rising rates, stable growth
Cap rates expand (higher)
Property values fall even at stable NOI
Stable rates, rising growth expectations
Cap rates compress
Property values rise on growth re-rating
Stable rates, falling growth expectations
Cap rates expand
Property values fall on growth de-rating
§ 04
Cap rate compression below historical spread norms is a signal worth investigating, not an automatic warning. Tight spreads can reflect rising growth expectations (sustainable if growth materializes), falling risk premiums (vulnerable to a sentiment reversal), or both. The investor exercise is to identify which piece is doing the work.
§ 05
The 2021-2023 cap-rate cycle illustrates the framework. From 2010-2021, industrial cap rates compressed roughly 200 basis points below historical norms — most of the compression was risk-premium driven (capital chasing yield in a low-rate world) layered on top of genuinely-rising NOI growth expectations from e-commerce. When the Treasury yield rose by roughly 300 basis points across 2022-2023, the risk-free piece more than absorbed the growth piece, cap rates expanded by 100-200 basis points, and property values fell 20-30 percent even though NOI continued to grow.
§ 06
Pick a property subsector you care about (industrial, multifamily, office, retail). Look up the latest market-average cap rate from a broker report (CBRE, JLL, or Newmark publish these). Subtract the current 10-year Treasury yield. Compare the spread to the long-run average — Green Street, Real Capital Analytics, and major brokers all publish historical spread series. A spread far below average means the market is pricing in higher growth or lower risk than historical norms; a spread far above average means the opposite.
§ 07
An apartment REIT trades at a 6 percent cap rate. The 10-year Treasury yields 4.5 percent, and the long-run spread for apartment cap rates over Treasuries is roughly 200 basis points. The current 150 basis point spread is unusually tight. What does the decomposition reasonably suggest the market is implying?
Five questions · AI feedback
●○○○○
Sit with the ideas.
An industrial property trades at a 5 percent cap rate when the 10-year Treasury yields 4.5 percent. A long-run average historical spread for industrial cap rates over Treasuries is roughly 250 basis points. The market is implying what about future NOI growth or about the risk premium investors require?
