CRE glossary
Capitalization Rate (Cap Rate)
The capitalization rate (cap rate) is a property's annual net operating income (NOI) divided by its market value or purchase price, expressed as a percentage. It represents the unlevered, first-year return on an all-cash purchase and is the primary lever the market uses to price commercial real estate.
Formula
Cap Rate = Net Operating Income (NOI) ÷ Property Value (or Purchase Price)
How cap rate is used
Cap rate serves three connected jobs in a CRE deal. As a pricing tool, it converts NOI into value: rearranging the formula, Value = NOI ÷ Cap Rate, so buyers and appraisers apply a market cap rate to a property's income to derive price. As a yield benchmark, it states the unlevered return an all-cash buyer earns in year one, letting analysts compare deals across markets and asset types on a debt-neutral basis. As a market signal, movement in prevailing cap rates ("cap rate compression" or "expansion") reveals how investor demand, interest rates, and risk appetite are repricing an entire sector.
- •Value = NOI ÷ Cap Rate — the standard direct-capitalization valuation method
- •Lower cap rate = higher price per dollar of NOI (and typically lower perceived risk)
- •Higher cap rate = lower price and/or higher perceived risk or slower growth
- •Exit cap rate (the rate assumed at sale) is one of the most sensitive inputs to projected returns
Why it matters
Cap rate is the single number that ties income to value, which is why it drives nearly every CRE decision. Because it strips out financing, it isolates the asset's own performance from the investor's loan terms — a clean, apples-to-apples measure of pricing. It also anchors the two ends of a hold: the going-in (entry) cap rate sets what you pay, and the exit cap rate assumed at sale often has a larger impact on IRR and equity multiple than rent growth itself. Underwriting an exit cap rate below the entry cap rate ('bake in' compression) is one of the most common ways pro-formas overstate returns.
Common pitfalls and nuances
Cap rate is only as trustworthy as the NOI and value that feed it, and both are frequently manipulated. NOI must be defined consistently — before debt service, before capital expenditures, before income taxes, and before depreciation — otherwise two 'cap rates' aren't comparable. Watch which NOI is used: a going-in cap rate on in-place (trailing) NOI can differ sharply from a stabilized or pro-forma cap rate built on projected, not-yet-realized income. A 'cap rate' quoted on optimistic broker pro-forma NOI will look artificially attractive.
- •In-place / trailing cap rate uses actual current NOI; pro-forma cap rate uses projected NOI
- •Cap rate ignores leverage, so it is not the levered cash-on-cash return investors actually earn
- •It also ignores future income growth — a low cap rate can be justified by strong rent growth (relationship: Cap Rate ≈ Discount Rate − Growth)
- •Reserves, management fees, and capital items excluded from NOI can quietly inflate the stated cap rate
- •A single cap rate says nothing about lease rollover, tenant credit, or timing of cash flows
Worked example
A stabilized multifamily property generates $1,200,000 in net operating income (gross rents and other income of $2,000,000 less $800,000 in operating expenses, before debt service and capex). It is listed at $20,000,000.\n\nCap Rate = $1,200,000 ÷ $20,000,000 = 0.06 = 6.0%\n\nIf a buyer requires a 6.5% going-in cap rate for this market and risk profile, they would solve for value: $1,200,000 ÷ 0.065 = $18,461,538 — roughly $1.54M below asking. Conversely, if cap rates compress to 5.5% by sale and NOI has grown to $1,400,000, the exit value would be $1,400,000 ÷ 0.055 = $25,454,545.
Frequently asked questions
- What is a good cap rate?
- There is no universal 'good' cap rate — it depends on asset class, market, and risk. Broadly, stabilized institutional properties in strong markets trade at lower cap rates (roughly 4.5%–6%) reflecting lower perceived risk, while secondary markets, older assets, or higher-risk sectors trade at higher cap rates (7%–9%+). A lower cap rate means you pay more per dollar of income; a higher cap rate means more income yield but usually more risk or less growth. The right cap rate is the one that fairly compensates you for that specific asset's risk relative to comparable sales.
- What is the difference between cap rate and cash-on-cash return?
- Cap rate is unlevered — it measures NOI against total property value, ignoring any loan. Cash-on-cash return is levered — it measures the actual pre-tax cash flow after debt service against the equity you invested. When debt is accretive (borrowing cost below the cap rate), cash-on-cash return exceeds the cap rate through positive leverage; when the loan constant is higher than the cap rate, leverage is negative and cash-on-cash falls below it.
- Does a lower cap rate mean a better deal?
- Not inherently. A lower cap rate means a higher price for the same income, which benefits sellers and reflects lower perceived risk or higher expected growth — not a bargain for buyers. A lower going-in cap rate only makes sense if you expect strong NOI growth or further cap-rate compression. Buyers generally want to acquire at a fair-to-higher cap rate and exit at a lower one; assuming that compression without justification is a classic way to overstate projected returns.
Keep exploring