California Real Estate Practice Exam

When interest rates on real property loans increase, capitalization rates on income properties tend to:

1. be affected inversely

2. increase

3. remain the same

4. decrease

The correct answer is: be affected inversely

When interest rates on real property loans increase, capitalization rates on income properties tend to increase as well. This is because higher interest rates typically indicate that borrowing costs are higher, which can lead investors to expect higher returns on their investments to compensate for the increased costs of financing. In essence, capitalization rates are calculated as the ratio of the net operating income (NOI) of a property to its current market value or purchase price. When interest rates rise, the cost of capital increases, making income properties less attractive unless their returns, reflected in the capitalization rate, also rise. Investors will seek a better return on their investment to offset the higher borrowing costs, thus leading to an increase in capitalization rates. This mechanism emphasizes the relationship between interest rates and capitalization rates: as interest rates rise, the expectation for return also rises, resulting in increased capitalization rates reflecting the need for a greater yield on investment properties.