Formula
Spread = Cap Rate − Reference Rate (expressed in basis points)
No separate source: the formula follows by arithmetic from the steps below, each with its own basis.
- Reference Rate
- Commonly the 10-year Treasury yield; also the borrowing constant, or a comparable asset class's cap rate.
Where the formula comes from
The cap rate is the net operating income for the year divided by the appraised value of the property.
Source: Commercial Mortgage Securities Association (now CRE Finance Council), Glossary of Terms: CMBS (updated March 2006) (opens in a new tab), “Capitalization Rate (Cap Rate)”: [I/V = R]
As this course defines it, the reference rate is a benchmark yield chosen for the comparison: most often the 10-year Treasury yield, sometimes the loan constant or another asset class's cap rate.
The course's own definition: it cites no published source.
The spread is the cap rate minus the reference rate. One percentage point is 100 basis points, so a 6.00% cap rate against a 4.50% reference rate is a spread of 1.50 points, or 150 basis points.
Arithmetic on the steps above.
How it works
The spread over Treasuries is the standard way to judge whether real estate is expensive or cheap relative to risk-free alternatives, rather than in absolute terms. A 6% cap rate when the 10-year Treasury yields 2% is a 400 basis point premium, historically generous. The same 6% cap rate when the Treasury yields 4.5% is a 150 basis point premium, which is thin compensation for illiquidity, management burden and tenant risk.
This reframes what "high cap rates" means. Cap rates rising from 5% to 6% is not by itself a buying opportunity; if Treasury yields rose 150 basis points over the same period, the risk premium actually compressed. The absolute level tells you about price; the spread tells you about relative value.
Spreads do not adjust instantly, and the lag creates the most reliable pattern in commercial real estate pricing. Treasury yields move daily; cap rates are revealed only through transactions, which are slow, negotiated and reported with delay. When rates rise sharply, spreads compress first, not because investors accepted less compensation, but because sellers had not yet repriced. Transaction volume then falls as bid and ask separate, and cap rates follow months later.
The spread between property types is the second common use, and it describes relative risk within real estate. When the gap between prime industrial and secondary office widens, the market is pricing greater divergence in the durability of those income streams. Narrowing spreads across asset classes usually signal abundant capital chasing yield rather than a genuine convergence in risk.
Worked example
An investor compares two periods. In Period A a property trades at a 5.25% cap rate with the 10-year Treasury at 1.75%. In Period B a similar property trades at a 6.50% cap rate with the Treasury at 4.40%.
| Step | Calculation | Result |
|---|---|---|
| Spread in Period A | 5.25% − 1.75% | 350 bps |
| Spread in Period B | 6.50% − 4.40% | 210 bps |
| Change in spread | 210 − 350 | −140 bps |
| Cap rate needed in Period B to restore a 350 bps spread | 4.40% + 3.50% | 7.90% |
| Price at 7.90% vs 6.50% on $600,000 NOI | $7,594,937 vs $9,230,769 | −17.7% |
Cap rates rose 125 basis points between the two periods, which looks like cheaper real estate. Measured against Treasuries the risk premium fell by 140 basis points, meaning investors are being paid less for taking property risk than before. Restoring the historical premium would require a 7.90% cap rate and a further 17.7% decline in price. This gap between absolute cap rates and spreads is why markets can feel cheap and be expensive at the same time.
Common mistakes
- Judging cap rates in absolute terms
- A 6% cap rate is generous against a 2% Treasury and thin against a 4.5% one. The level alone carries no information about value.
- Comparing a cap rate spread against a short-term rate
- The 10-year Treasury is the conventional benchmark because its duration roughly matches a real estate hold period. Using the Fed funds rate compares against a different time horizon.
- Expecting spreads to correct immediately
- Cap rates are revealed through slow, negotiated transactions. A compressed spread can persist for several quarters before pricing adjusts.
Frequently asked questions
- What is a cap rate spread?
- The difference between a property's capitalization rate and a benchmark rate, most commonly the 10-year Treasury yield. It expresses the risk premium investors demand for owning real estate rather than a risk-free government bond.
- What is a normal cap rate spread over Treasuries?
- Historically the premium has often sat in the region of 250 to 400 basis points for institutional-quality assets, though it varies widely by property type, market cycle and capital availability. The useful comparison is against that asset class's own history rather than a single universal figure.
- What does it mean when cap rate spreads compress?
- That cap rates have not risen as much as benchmark rates, so investors are receiving less compensation for property risk. It often reflects sellers who have not yet repriced rather than a deliberate acceptance of lower returns, and it is typically followed by falling transaction volume and later by cap rate expansion.