Cap Rate Explained: What It Is, How to Calculate It, and When It Matters

The capitalization rate—commonly referred to as the cap rate—is one of the most widely used metrics in commercial real estate. It plays a central role in how properties are valued, compared, and priced across markets and asset classes.

While cap rate is a powerful tool, it is often misunderstood or misused. Understanding what it measures, how it is calculated, and when it is most relevant can help investors make more informed decisions and avoid common pitfalls.

What Is a Cap Rate?

The cap rate represents the rate of return a property is expected to generate based on its income relative to its value or purchase price.

In simple terms, it answers the question: “If I bought this property with cash, what return would the income produce?”

Cap rate does not account for financing, tax considerations, or future growth assumptions. It is a snapshot of a property’s current income performance.

How to Calculate Cap Rate

The cap rate formula is straightforward:

Cap Rate = Net Operating Income (NOI) ÷ Purchase Price

Example:

• Net Operating Income: $500,000

• Purchase Price: $10,000,000

Cap Rate = $500,000 ÷ $10,000,000 = 5.0%

This means the property produces a 5 percent return based on current income and price.

Why Cap Rate Matters in Commercial Real Estate

Cap rates are used across the industry for several key purposes:

Property Valuation

Cap rates are central to income-based valuation. A property’s value can be estimated by dividing NOI by the market cap rate.

Value = NOI ÷ Cap Rate

Small changes in cap rate can significantly impact value, especially for larger assets.

Comparing Investment Opportunities

Cap rates allow investors to compare different properties quickly, even across markets or asset classes. When applied correctly, they help normalize pricing relative to income.

Assessing Risk

Cap rates often reflect perceived risk. Generally:

• Lower cap rates are associated with lower-risk, more stable assets

• Higher cap rates often indicate higher risk or uncertainty

Risk factors that influence cap rates include tenant credit, lease length, asset condition, location, and market fundamentals.

What Is a “Good” Cap Rate?

There is no universal “good” cap rate. What is considered attractive depends on several variables, including market conditions, interest rates, asset type, and investor strategy.

In broad terms:

• Core, stabilized assets in strong markets tend to trade at lower cap rates

• Value-add or higher-risk assets typically command higher cap rates

Cap rates also vary by asset class. Industrial, office, retail, and multifamily properties each have their own market benchmarks.

Cap Rate vs. Cash Flow

Cap rate measures return before financing, while cash flow reflects what an investor actually earns after debt service.

A property can have a strong cap rate but still produce negative cash flow if financing terms are aggressive. Conversely, a lower cap rate deal can generate healthy cash flow with favorable debt.

This is why cap rate should always be evaluated alongside cash flow, debt service coverage, and financing assumptions.

When Cap Rate Matters Most

Cap rate is particularly useful in the following situations:

• Comparing stabilized, income-producing properties

• Valuing assets in established markets

• Evaluating acquisitions where income is predictable

When Cap Rate Matters Less

Cap rate is less effective for:

• Properties with unstable or transitional income

• Development or redevelopment projects

• Short-term value-add investments with significant income growth assumptions

In these cases, metrics like cash-on-cash return and internal rate of return (IRR) provide better insight.

Common Cap Rate Misconceptions

One of the most common mistakes investors make is relying on cap rate alone. Cap rate does not account for:

• Financing structure

• Future rent growth

• Capital expenditures

• Market timing

Cap rate is a starting point—not a complete analysis.

Final Thoughts

Cap rate remains one of the most important metrics in commercial real estate, but its value lies in how it is used. When combined with NOI analysis, cash flow projections, and financing metrics, cap rate provides meaningful insight into pricing, risk, and market value.

Understanding when cap rate matters—and when it does not—allows investors to move beyond surface-level comparisons and evaluate opportunities with greater confidence.

Written by LevRose CRE with assistance from: LevRoseCRE.(2024)

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