By: Trey Webb | 10/20/25
Why Interest Rates Matter in Real Estate
Interest rates are a fundamental driver of the real estate market, influencing everything from property values and investor returns to the cost of financing and the overall health of the sector. Whether you’re a developer, investor, or property owner, understanding the relationship between interest rates and real estate is essential for making informed decisions.
At their core, interest rates represent the cost of borrowing money. When the Federal Reserve adjusts its benchmark rates, the effects ripple through the economy, impacting mortgage rates, construction loans, and the yields investors demand from real estate assets. Even small changes in rates can have outsized effects on property values, cash flows, and investment strategies.
The Impact of Rising Interest Rates on Property Values and Cash Flow
When interest rates rise, borrowing becomes more expensive. For real estate investors and developers, this means higher costs for new loans and refinancing. The immediate effect is often a reduction in purchasing power for both homeowners and investors, as higher monthly payments limit the amount buyers can afford.
One of the most direct rising interest rates effect on real estate is the upward pressure on capitalization (cap) rates. Cap rates are used to value income-producing properties by dividing net operating income by the property’s value. As interest rates increase, investors typically demand higher returns to compensate for the increased cost of capital and the availability of alternative investments with better yields. This leads to higher cap rates, which, all else being equal, result in lower property values.
For example, if a property generates $100,000 in net operating income and the prevailing cap rate rises from 5% to 6% due to an interest rate hike, the property’s value drops from $2 million to about $1.67 million. This inverse relationship between cap rates and property values is a key reason why rising interest rates can cool real estate markets.
Rising interest rates also increase the cost of servicing debt. For leveraged investors, higher interest payments can erode cash flow, making some investments less attractive or even unprofitable. This is particularly relevant for properties with variable-rate loans or those approaching refinancing. According to IRS Publication 527, mortgage interest is a deductible expense for rental property owners, but higher rates still reduce after-tax cash flow.
Higher rates can slow transaction volume as buyers and sellers adjust to new pricing realities. Sellers may be reluctant to accept lower prices, while buyers may wait for more favorable conditions. This can lead to a period of market stagnation, especially in sectors where financing is a critical component of deal-making.
What Falling Interest Rates Mean for Investors
Conversely, falling interest rates generally stimulate real estate activity. Lower borrowing costs make it easier for investors and homeowners to finance purchases, often leading to increased demand and upward pressure on property values.
When rates drop, monthly payments on new loans decrease, allowing buyers to afford more expensive properties or to purchase additional assets. This increased demand can drive up prices, particularly in markets with limited supply. For investors, lower rates can mean higher leveraged returns, as the spread between property yields and borrowing costs widens.
Falling rates also present opportunities for existing property owners to refinance at lower costs, improving cash flow and potentially freeing up capital for additional investments. The IRS allows for the deduction of mortgage interest on investment properties, and refinancing at a lower rate can enhance the after-tax return on investment.
While falling rates generally benefit most real estate investments, rising rates do not affect all property types equally. Historically, sectors with shorter lease terms, such as hotels and multifamily properties, can adjust rents more quickly to keep pace with inflation and rising rates. In contrast, properties with long-term leases may see values decline if their income streams lag behind market rates.
Strategic Adjustments: Financing, Holding, and Selling Decisions
In a rising rate environment, locking in fixed-rate financing becomes a prudent mortgage rate strategy. Fixed-rate loans provide certainty and protect against future rate increases. For new acquisitions, investors may consider shorter-term or adjustable-rate loans if they anticipate rates will fall or if they plan to sell or refinance before rates reset.
Rising rates may prompt investors to hold properties longer, waiting for more favorable market conditions. Alternatively, some may accelerate sales to avoid refinancing at higher rates. Asset management becomes critical, with a focus on improving property performance, reducing expenses, and increasing rents where possible to offset higher debt costs
When rates are rising, sellers may need to adjust pricing expectations. Properties with strong, stable cash flows and desirable locations will remain attractive, but buyers will be more sensitive to pricing and projected returns. In a falling rate environment, sellers may benefit from increased buyer demand and higher valuations.
A study by the National Association of Realtors found that during periods of rising interest rates, commercial real estate transaction volume often slows, but property values do not always decline immediately. Instead, there is often a lag as the market adjusts. In contrast, when rates fall, transaction volume and prices tend to rise more quickly, reflecting increased investor confidence and access to cheaper capital.
How Bennett Thrasher Helps Real Estate Investors Stay Ahead
Navigating the complexities of interest rates and real estate requires more than just market knowledge—it demands proactive planning, sophisticated modeling, and a deep understanding of tax implications. Bennett Thrasher’s real estate advisory team works closely with investors, developers, and property owners to:
By combining technical expertise with real-world experience, Bennett Thrasher helps clients develop resilient strategies that maximize returns and minimize risk—regardless of where interest rates are headed.
FAQ
How do interest rate hikes affect cap rates?
Interest rate hikes typically lead to higher cap rates, as investors demand greater returns to compensate for increased borrowing costs and alternative investment opportunities. Higher cap rates, in turn, generally result in lower property values, assuming net operating income remains constant. This relationship is a key reason why monitoring the interest rate on investment properties is crucial for both buyers and sellers.
Should I refinance a property when rates drop?
Refinancing when rates drop can be a smart strategy, as it reduces your borrowing costs and can improve cash flow. However, it’s important to consider transaction costs, prepayment penalties, and your investment horizon. If you plan to hold the property long enough to recoup the costs of refinancing, and the new rate is significantly lower, refinancing can enhance your returns and free up capital for other investments. Always consult with a tax advisor to understand the full implications for your specific situation.
Conclusion
Interest rates are a powerful force in real estate, shaping values, cash flows, and investment strategies. Whether rates are rising or falling, understanding their impact and working with experienced advisors like Bennett Thrasher can help you make the best investments for rising interest rates and beyond. By staying informed and proactive, real estate investors can navigate changing markets with confidence and success.
Trey Webb
Bennett Thrasher LLP
Phone: (770) 396-2200
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