Capitalization Rate (Cap Rate)

The capitalization rate, or cap rate, is a common metric in commercial real estate that estimates an investment property’s unlevered annual rate of return. It’s calculated by dividing a property’s net operating income by its current market value and is used to compare the relative value and risk of similar properties.

Key takeaways

• Cap rate = Net Operating Income (NOI) / Current Market Value (expressed as a percentage).
• It estimates the unlevered (cash purchase) return and is best for comparing similar properties.
• Cap rates do not account for leverage, time value of money, future cash flows from improvements, or irregular incomes.

How the cap rate is calculated

Primary formula:
Cap rate = Net Operating Income / Current Market Value

Where:
* Net Operating Income (NOI) = expected annual rental and other income minus operating expenses (maintenance, property taxes, management, etc.).
* Current Market Value = the present market price of the property.

A less common variant uses the purchase price (Cap rate = NOI / Purchase Price), but this can be misleading for older acquisitions or inherited properties and is generally less useful than using current market value.

What the cap rate tells you

• Payback horizon: A cap rate of X% implies roughly 1/X years to recover the cash purchase price (e.g., a 10% cap rate ≈ 10 years).
• Relative risk: Higher cap rates typically imply higher perceived risk or lower property valuation; lower cap rates imply lower risk and higher valuation.
• Comparison tool: Useful for quick comparisons among similar assets in the same market, but not a standalone valuation method.

Example context: A well-located, high-demand property often has a lower cap rate because its market value is higher relative to income; a less desirable property tends to show a higher cap rate.

Gordon Growth Model perspective

Using a dividend-discount–style view, cap rate ≈ required rate of return − expected income growth rate.

Example:
* NOI = $50,000; expected NOI growth = 2%; investor’s required return = 10%
* Cap rate ≈ 10% − 2% = 8% → implied value = $50,000 / 8% = $625,000

This framing ties cap rates to investor return expectations and expected growth.

Limitations

• Ignores financing (leverage) — cap rate assumes a cash purchase.
• Not a full cash-flow model — it ignores multi-year cash flow variability, capex needs, and the time value of money. DCF (discounted cash flow) models are preferable when cash flows are irregular or when you need a detailed valuation.
• Sensitive to NOI and market value inputs — small changes in either can materially alter the cap rate.
• Market- and property-specific — comparisons are meaningful only among similar asset types and locations.

Factors that affect cap rates

• Location and market demand/supply.
• Property type (multifamily, office, retail, industrial, etc.).
• Tenant creditworthiness and lease terms.
• Property age, condition, and required capital expenditures.
• Local economic trends and expected rental growth.
• Prevailing interest rates — generally, cap rates trend up when interest rates rise.
• Renovations or improvements that increase rents or reduce vacancy.

Examples

Scenario: $1,000,000 purchase price
* Annual rent receipts = $90,000; operating expenses = $20,000 → NOI = $70,000 → Cap rate = 70,000 / 1,000,000 = 7%.
Tenant move-outs reduce rent to $40,000; NOI = 40,000 − 20,000 = $20,000 → Cap rate = 2%.
Operating costs rise to $50,000 while rent stays at $90,000 → NOI = 40,000 → Cap rate = 4%.
* Market value falls to $800,000 with NOI = $70,000 → Cap rate = 8.75%.

These illustrate how changes in income, expenses, or property value affect cap rates and perceived returns relative to risk-free alternatives (e.g., Treasury yields).

What is a “good” cap rate?

There’s no universal “good” cap rate. Typical observed ranges for commercial properties are about 4% to 10%, but acceptable levels depend on:
* Investor risk tolerance (higher cap rates for higher-risk investments).
* Market dynamics, property type, and expected growth.
Use cap rates as one input among others (DCF, ROI, vacancy assumptions, lease structures, and local market analysis).

Practical guidance

• Use cap rates to screen and compare similar properties in the same market.
• Combine cap-rate analysis with DCF models, ROI calculations, and assessments of financing structure, tenant quality, and capex needs.
• Adjust expectations based on interest rates and local market fundamentals.
• Verify and stress-test NOI assumptions (vacancy, rent growth, operating cost variability).

FAQ

Q: Should my cap rate be between 4% and 10%?
A: That range is common, but the “right” cap rate depends on market, property type, and your required return.

Q: Is a higher or lower cap rate better?
A: Neither is universally better. A higher cap rate usually signals higher risk but higher potential return; a lower cap rate signals lower risk and lower relative return.

Q: How is cap rate different from return on investment (ROI)?
A: Cap rate estimates the unlevered annual return based on current income and value. ROI can incorporate leverage, time horizon, total cash flows, and capital gains — it’s typically broader.

Bottom line

The cap rate is a useful, quick metric to estimate the unlevered return and compare similar commercial properties. Treat it as an initial screening tool, not a comprehensive valuation. Always supplement cap-rate analysis with detailed cash-flow modeling, market research, and risk assessment.