Short for capitalization rate, a "cap rate" is the unlevered annual cash-on-cash yield of a real estate investment. Divide an investment property’s annual net operating income (“NOI”) by the asset value, and you have the annual yield assuming an all-cash investment.
Since most investors use debt to acquire investment property, they are underwriting the investment on a levered basis using an internal rate of return investment analysis. With debt involved in the equation, a real estate investment takes on considerably more risk than owning a property with no debt, and using a cap rate when a property is levered as a barometer for reflecting a risk-adjusted return compared to the 10-year Treasury, is not particularly relevant.
In addition, investors use cap rates in their underwriting analysis like a comparable, to check a sales price or valuation of a property, compared to other simlar transactions. Cap rates are also used in an investment analysis as a way to calculate a terminal value at the end of the projected investment period.
Spreads have been increasing, which means as the Spread moves back into a more historical norm, otherwise referred to as "cap rate compression", property values will go up the same way bond values go up when interest rates come down.
With Spreads at historical highs, investment real estate looks like a very attractive asset class.