What Is a Cap Rate?

The Cap Rate Formula

Cap Rate = Net Operating Income (NOI) / Property Value (or Purchase Price)

The capitalization rate expresses the relationship between a property's income and its value as a percentage. It answers a simple question: if you bought this property with all cash (no financing), what annual return would the property's net income represent on your investment?

A 7% cap rate means the property generates income equal to 7% of its value each year before financing costs. A 4% cap rate means the property generates 4%. The cap rate is an unlevered return metric, meaning it does not account for mortgage payments, leverage, or tax effects. It isolates the property's income-producing capacity from the financial engineering applied to it.

This makes cap rates useful for comparing properties across different financing structures, markets, and investor situations. Two investors can buy the same property with different financing and different leveraged returns, but the cap rate is the same for both because it measures the property, not the deal.

Worked Example: 50-Unit Apartment Building

Consider a 50-unit multifamily property in a secondary market:

Income:

• Average monthly rent per unit: $950
• Gross potential rent: 50 units x $950 x 12 months = $570,000
• Other income (laundry, parking, storage, application fees): $18,000
• Gross potential income: $588,000
• Less vacancy and collection loss (5%): -$29,400
• Effective gross income: $558,600

Operating Expenses:

• Property taxes: $52,000
• Insurance: $24,000
• Property management (7% of EGI): $39,102
• Maintenance and repairs: $40,000
• Utilities (common areas and owner-paid): $22,000
• Administrative, legal, and accounting: $12,000
• Replacement reserves ($300/unit/year): $15,000
• Landscaping and snow removal: $9,000
• Pest control, turnover costs, miscellaneous: $5,498
• Total operating expenses: $198,600 (35.6% expense ratio)

NOI = $558,600 - $198,600 = $360,000 Purchase price: $4,000,000 Cap Rate = $360,000 / $4,000,000 = 9.0%

This means that if you purchased the property for $4,000,000 in cash, the annual net operating income would represent a 9.0% return on your investment.

Cap Rates by Property Type

Cap rates vary significantly by property type, class, and market. Higher cap rates indicate higher perceived risk, lower demand, or less desirable property characteristics. Lower cap rates indicate institutional demand, perceived stability, and growth expectations.

The following table reflects market observations as of the second half of 2025, drawing on transaction data reported by CBRE and other institutional brokerage reports:

Source: CBRE Cap Rate Survey, H2 2025. Cap rates represent market averages and vary significantly by location, tenant quality, lease term, and property condition.

Cap Rate vs. Cash-on-Cash Return

Cap rate and cash-on-cash return are both expressed as percentages, but they measure fundamentally different things:

### Example Comparison

Using the 50-unit building above ($4M purchase price, $360K NOI):

Cap rate (unlevered): $360,000 / $4,000,000 = 9.0%

Now add financing: $3,000,000 loan at 6.75% for 30 years (75% LTV). Annual debt service: $264,000. Cash invested: $1,000,000 (25% down payment).

Annual pre-tax cash flow: $360,000 (NOI) - $264,000 (debt service) = $96,000 Cash-on-cash return: $96,000 / $1,000,000 = 9.6%

In this example, leverage slightly improved the return from 9.0% to 9.6% because the property's cap rate (9.0%) exceeds the cost of debt (~6.75%). This positive leverage amplifies returns. If the cost of debt exceeded the cap rate, leverage would reduce returns (negative leverage).

How Cap Rates Relate to Market Conditions

Cap rates are inversely related to property values. When cap rates compress (decrease), property values increase for the same NOI. When cap rates expand (increase), property values decrease.

This relationship is driven by several macroeconomic and market factors:

Interest rates. Cap rates generally move in the same direction as interest rates, but not in lockstep. When interest rates rise (as they did from 2022-2024), the cost of financing increases, reducing what leveraged buyers can pay, which pushes cap rates up. When rates fall, cap rates tend to follow. The spread between cap rates and treasury yields is a measure of the risk premium investors demand for owning real estate. Capital flows. When institutional capital floods into a property type (as it did with industrial and multifamily in 2020-2022), competition drives cap rates down. When capital retreats (as it did from office starting in 2023), cap rates expand. Supply and demand for space. Strong tenant demand and limited new supply support rents, which supports NOI, which supports values. Oversupply or weak demand pressures rents and vacancies, which depresses NOI and pushes cap rates up. Risk perception. Cap rates embed the market's assessment of risk. A single-tenant NNN-leased industrial building with Amazon on a 15-year lease trades at a 4.5% cap rate because the income stream is perceived as nearly risk-free. A 30-year-old strip mall with 40% vacancy trades at a 10%+ cap rate because the income stream is uncertain and declining.

When Cap Rate Analysis Misleads

Cap rate is a powerful tool, but it has limitations that can mislead investors who apply it mechanically:

1. Properties with Below-Market or Above-Market Rents

The cap rate is based on current NOI. If rents are significantly below market, the cap rate overstates the property's yield relative to its potential. A property with below-market rents at a 5% cap rate may actually represent a 7% cap rate on market rents. Conversely, a property with above-market rents (perhaps due to a single tenant paying over market on a lease that expires next year) may show an attractive cap rate that is not sustainable.

2. Properties Requiring Significant Capital Expenditure

NOI excludes capital expenditures. A property with a 9% cap rate but a $500,000 roof replacement needed in the next 12 months has a very different true yield than a property with a 9% cap rate and no deferred maintenance. The cap rate does not capture the capital investment required to maintain the income stream.

3. Properties with Non-Stabilized Occupancy

A property at 60% occupancy will show a low NOI and an apparently high cap rate (or negative NOI). This does not mean the property is a bargain at a high cap rate. It means the property is not stabilized, and the cap rate is not meaningful until the property reaches market occupancy. Value-add and lease-up deals should be evaluated on projected stabilized cap rate, not current cap rate.

4. Properties with Non-Recurring Income or Expenses

One-time events (a large insurance settlement, a one-year tenant improvement reimbursement, a lawsuit settlement) can inflate or deflate NOI in a single year, distorting the cap rate. Lenders and sophisticated investors normalize NOI by removing one-time items before calculating the cap rate.

5. Comparing Across Different Property Types or Markets

A 6% cap rate on a Class A multifamily building in a gateway city is not comparable to a 6% cap rate on a suburban office building in a tertiary market. The risk, growth potential, liquidity, and exit options are completely different. Cap rates are most useful when comparing similar properties in similar markets and of similar quality.

Using Cap Rate to Estimate Property Value

The cap rate formula can be inverted to estimate a property's value based on its income:

Estimated Property Value = NOI / Cap Rate

If a property generates $200,000 in NOI and comparable properties in the area are trading at a 7.5% cap rate:

Estimated value = $200,000 / 0.075 = $2,666,667

This is the income approach to valuation, and it is the primary method appraisers use for income-producing commercial properties. The accuracy of this estimate depends entirely on two inputs: the reliability of the NOI figure and the appropriateness of the cap rate applied.

Common errors in this calculation:

• Using a pro forma NOI instead of actual trailing twelve-month income.
• Applying a cap rate from a different market or property type.
• Not adjusting the cap rate for the specific property's condition, age, and location relative to comparable sales.

Frequently Asked Questions

Is a higher or lower cap rate better?

It depends on your perspective. As a buyer, a higher cap rate means more income per dollar invested (higher yield) but typically indicates higher risk, less desirable location, or older property. A lower cap rate means you pay more per dollar of income (lower yield) but the property is perceived as lower risk with better appreciation potential. As a seller, a lower cap rate environment means your property is worth more for the same income.

How do I find the right cap rate for my market?

Cap rate data is published by institutional brokerage firms (CBRE, JLL, Cushman & Wakefield, Marcus & Millichap) in quarterly or semi-annual reports. Local commercial brokers can provide cap rate ranges for specific property types and submarkets. Appraisers derive cap rates from recent comparable sales. The most reliable cap rate for your deal comes from sales of similar properties in the same market within the past 6-12 months.

Does cap rate account for appreciation?

No. Cap rate measures current income yield only. It does not include property value appreciation, rent growth, principal paydown through amortization, or tax benefits. Total return for a real estate investment includes all of these components. An investor may accept a lower cap rate (say 4.5% on a Class A multifamily) because they expect 3-4% annual rent growth, which would increase total returns significantly over a 10-year hold.

What cap rate do lenders use for underwriting?

Lenders often use a "stress" cap rate higher than the market cap rate to test the property's value under adverse conditions. For example, if the market cap rate is 6%, the lender might underwrite at 7% or 7.5% to ensure the loan is safe even if the market softens. This is called a "terminal" or "exit" cap rate and is used to estimate the property's future value at the end of the loan term.

Can cap rate be negative?

Technically, a property with negative NOI (operating expenses exceed income) would produce a negative cap rate calculation, but this is not meaningful. A negative NOI means the property is not a viable income investment in its current state. Properties with negative NOI are valued based on land value, redevelopment potential, or other metrics rather than cap rate.

Next Steps

Cap rate is the starting point for evaluating any income-producing commercial property. It tells you what the property earns relative to its cost, independent of financing. Use it to compare opportunities, estimate values, and set return expectations, but always consider its limitations.

Use our cap rate calculator to run the numbers on your deal and see how different cap rate assumptions affect estimated property value.