If you’re investing in commercial real estate (CRE), one term you’ll hear often is “cap rate” — short for capitalization rate. This simple but powerful formula is central to evaluating whether a property is a good investment. In this guide, we’ll break down what cap rate means, how it’s calculated, and how investors actually use it in decision-making.
What Is Cap Rate?
Cap rate is a financial metric that expresses the expected rate of return on a real estate investment property, based on its net operating income (NOI) relative to its current market value.
Cap Rate Formula:
Cap Rate = Net Operating Income (NOI) ÷ Property Value
Example:
If a property has an NOI of $120,000 and is valued at $2,000,000:
Cap Rate = 120,000 / 2,000,000 = 0.06 → or 6%
This tells investors that, if they purchase the property for $2 million, they can expect a 6% return annually based on income — before financing or taxes.
Why Is Cap Rate Important in CRE?
Cap rate serves several essential purposes in commercial real estate investing:
1. Quick Investment Comparison
It allows investors to compare the income-generating potential of different properties on a like-for-like basis.
Value ≈ NOI ÷ Market Cap Rate
2. Valuation Tool
Cap rates help estimate the fair market value of a property by linking value to income:
3. Risk Assessment
A higher cap rate often implies higher risk, while a lower cap rate suggests lower risk and stronger market fundamentals.
4. Market Indicator
Tracking cap rate trends can reveal broader market conditions — compression (falling cap rates) may indicate rising asset prices and investor confidence.
How to Calculate Cap Rate
Here’s a simple process:
1. Determine NOI
- NOI = Gross Income – Operating Expenses
Do not include mortgage payments, capital expenditures, or taxes.
2. Find Market Value
- Use the property’s sale price or appraised market value.
3. Apply the Formula
- Cap Rate = NOI ÷ Market Value
Example:
- NOI: $350,000
- Property Value: $5,000,000
- Cap Rate = 7%
What Is a Good Cap Rate?
There’s no one-size-fits-all answer. “Good” depends on:
- Asset type (multifamily, retail, office, industrial)
- Location (urban vs rural, growth markets vs stable markets)
- Risk profile (lease terms, tenant quality, age of building)
- Interest rate environment
Typical Ranges by Asset Class:
- Core urban multifamily: 4%–5%
- Retail strip centers: 6%–8%
- Industrial warehouses: 5%–7%
- Office buildings: 6%–9%
Investors usually seek higher cap rates when the perceived risk is higher — and accept lower cap rates when the asset is more stable.
Practical Uses of Cap Rate for Investors
Here’s how smart CRE investors leverage cap rate in real deals:
Screening Deals
Quickly assess whether a property meets your minimum return expectations.
Underwriting Offers
Back into the right offer price using target cap rates:
If you want a 7% return on a property with $210,000 NOI, offer:
$210,000 ÷ 0.07 = $3,000,000
Evaluating Market Trends
Monitor how cap rates move in response to interest rates, supply/demand, and macroeconomic shifts.
Projecting Exit Values
Use “exit cap rate” assumptions to model resale values and investment returns.
Cap Rate vs Other CRE Metrics
| Metric | What It Measures | Includes Debt? |
|---|---|---|
| Cap Rate | Return based on current income vs value | ❌ No |
| Cash-on-Cash | Return on invested equity | ✅ Yes |
| IRR | Total return over time, including timing | ✅ Yes |
Tip: Cap rate is a starting point — not the final word. Use it in conjunction with IRR, cash flow, and market comps for complete analysis.
Limitations of Cap Rate
While incredibly useful, cap rate has a few limitations:
- Doesn’t account for financing or leverage
- Reflects current income, not future growth or value-add potential
- Requires accurate NOI — which isn’t always transparent
- Not ideal for short-term holds or development projects
- Can vary wildly by market, asset class, and cycle stage
Conclusion
Cap rate is one of the most important metrics in commercial real estate. It helps investors evaluate return potential, compare properties, and assess market value — all with a simple formula. But like any metric, it must be understood in context.
Use cap rate as your quick check, but dig deeper into the deal’s full financials, market data, and long-term strategy.
Need help evaluating a CRE deal?
Or want more content like this? Let me know — I can help draft guides, calculators, or visuals to support your real estate strategy.
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