What is a Cap Rate?
The cap rate (capitalization rate) is one of the most fundamental metrics in commercial real estate. It tells you how much return a property generates relative to its price—and it's used by investors, lenders, and appraisers to value properties. This guide covers everything beginners need to know.
Cap Rate Definition
Cap rate (capitalization rate) is the ratio of a property's Net Operating Income (NOI) to its market value or purchase price. It represents the expected annual return if you bought the property with all cash. A 6% cap rate means the property generates 6% of its value in annual income.
Also called: Capitalization rate, Cap, Yield (in some markets)
The Cap Rate Formula
Cap Rate = NOI ÷ Property Value
You can rearrange this to solve for value:
Property Value = NOI ÷ Cap Rate
The formula is simple, but understanding what it tells you is key. Let's look at a quick example:
Finding the Cap Rate
A property has:
- NOI: $120,000/year
- Price: $2,000,000
Cap Rate = $120,000 ÷ $2,000,000
Cap Rate = 6.0%
Finding the Value
A property has:
- NOI: $120,000/year
- Market cap rate: 6%
Value = $120,000 ÷ 0.06
Value = $2,000,000
Cap Rate Explained Simply
Think of cap rate as the annual percentage return you'd earn if you paid all cash. It's like an interest rate for your real estate investment.
If you put $1,000,000 in a savings account earning 4% interest, you'd get $40,000/year. If you buy a property for $1,000,000 at a 6% cap rate, you'd get $60,000/year in NOI (before mortgage payments, if any).
The key insight: cap rate is the inverse of a price multiple. A 5% cap rate means you're paying 20x annual income. A 10% cap rate means you're paying 10x annual income. Lower cap rate = higher price.
The Inverse Relationship
Cap rate and value move in opposite directions. When cap rates go down, property values go up (and vice versa). This is why investors watch cap rate trends closely—cap rate compression means values are rising.
What Affects Cap Rates?
Cap rates aren't arbitrary—they reflect the market's assessment of risk and return. Several factors influence where cap rates land:
Location
Prime markets (NYC, SF, LA) have lower cap rates. Secondary and tertiary markets have higher cap rates due to less demand and liquidity.
Property Type
Industrial and multifamily often have lower cap rates (high demand). Retail and office may have higher cap rates due to sector headwinds.
Tenant Quality
Credit tenants (Walgreens, FedEx) with long-term leases command lower cap rates. Mom-and-pop tenants or short-term leases mean higher cap rates.
Lease Term
Longer remaining lease terms provide income stability and lower cap rates. Short remaining terms or near-term expirations mean higher cap rates.
Property Condition
Newer, well-maintained properties have lower cap rates. Older properties or those needing capital improvements have higher cap rates.
Interest Rates
When interest rates rise, cap rates tend to rise (values fall). When rates drop, cap rates compress (values rise). The spread vs. Treasuries matters.
Typical Cap Rates by Property Type
Cap rates vary significantly by asset class. These ranges are approximate for stabilized properties in average markets (2024-2025):
| Property Type | Typical Cap Rate | Why |
|---|---|---|
| Industrial / Warehouse | 5.0–6.5% | E-commerce demand, long-term leases, low maintenance |
| Multifamily | 5.0–6.5% | Essential housing, recession-resistant, rent growth potential |
| Self-Storage | 5.5–7.0% | Low CapEx, sticky tenants, but smaller investor pool |
| Retail (NNN) | 5.5–7.5% | Credit tenants command lower caps; weaker tenants higher |
| Office | 6.5–9.0% | Remote work impact, high TI costs, sector uncertainty |
| Hotels | 7.0–10.0% | Operating business risk, economic sensitivity, high CapEx |
Cap Rates Change Over Time
These ranges shift based on interest rates, market conditions, and capital flows. Always check current market data. Cap rates in 2024-2025 are higher than 2021-2022 due to rising interest rates.
How Cap Rate Changes Affect Value
Small changes in cap rate have a big impact on property value. This is especially important during market shifts when cap rates are moving.
Same Property ($100,000 NOI) at Different Cap Rates
| Cap Rate | Property Value | Change from 6% |
|---|---|---|
| 4.0% | $2,500,000 | +$833,333 |
| 5.0% | $2,000,000 | +$333,333 |
| 6.0% | $1,666,667 | — |
| 7.0% | $1,428,571 | −$238,095 |
| 8.0% | $1,250,000 | −$416,667 |
Why This Matters
A 100 basis point (1%) cap rate increase from 6% to 7% destroys $238,000 in value on a $100K NOI property. This is why rising interest rate environments can be painful for property owners—even if NOI stays constant, values can decline.
Going-In vs. Exit Cap Rate
When underwriting deals, investors use two different cap rate concepts:
Going-In Cap Rate
The cap rate at purchase—calculated using current NOI and purchase price.
Current NOI ÷ Purchase Price
Example: $100,000 NOI ÷ $1,666,667 = 6.0% going-in cap
Exit Cap Rate
The assumed cap rate at sale—used to project future sale price.
Projected NOI at Sale ÷ Projected Sale Price
Typically 0.25-0.50% higher than going-in to be conservative
Example: 5-Year Hold Analysis
Purchase
$1,666,667 at 6.0% cap
($100,000 Year 1 NOI)
Sale (Year 5)
$1,846,154 at 6.5% cap
($120,000 Year 5 NOI)
The investor assumes NOI grows to $120,000 by Year 5, but the exit cap rate is 0.5% higher than purchase to be conservative. This projects a sale price of $1,846,154.
Who Uses Cap Rates?
Investors & Buyers
Compare investment opportunities and determine fair value for acquisitions.
Sellers
Price properties competitively based on current market cap rates.
Lenders
Assess property value and loan-to-value ratios for underwriting.
Appraisers
Value properties using the income approach (NOI ÷ Cap Rate).
Brokers
Market properties and advise clients on pricing strategies.
Analysts
Track market trends and compare property performance across portfolios.
Limitations of Cap Rates
Cap rates are useful but not perfect. Be aware of these limitations:
Ignores Financing
Cap rate assumes all-cash purchase. It doesn't tell you the leveraged return (cash-on-cash). Two investors buying the same property will have different returns based on their financing.
Ignores Growth
Cap rate is a snapshot of Year 1 income. It doesn't account for rent growth, value-add potential, or future NOI increases. A low-cap property may have better total returns if rents are growing faster.
Ignores Capital Needs
A property with a high cap rate may need significant capital expenditures (new roof, HVAC, etc.). The "discount" in cap rate may reflect future costs not captured in NOI.
Can Be Manipulated
Sellers may present "pro forma" cap rates based on projected NOI rather than actual. Always verify the NOI yourself using historical financials (T12 statements).
Calculate Cap Rates Instantly
Use our free cap rate calculator to value properties, compare deals, and understand how NOI changes affect value.
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Frequently Asked Questions
Common questions about cap rates