Formula
Cap Rate = Net Operating Income ÷ Value (so Value = NOI ÷ Cap Rate)
Source: Commercial Mortgage Securities Association (now CRE Finance Council), Glossary of Terms: CMBS (updated March 2006) (opens in a new tab), “Capitalization Rate (Cap Rate)”: [I/V = R]
- Net Operating Income
- Typically the forward twelve months of stabilized income; a trailing figure produces a trailing cap rate and the two are not interchangeable.
- Value
- The appraised value of the property.
How it works
A cap rate is a price expressed as a yield, and it inverts: a 5% cap rate means paying twenty times annual income, while an 8% cap rate means paying twelve and a half times. Lower cap rates mean higher prices. This inversion is the single most common source of confusion for people new to the field, because "cap rates went up" sounds positive and means values went down.
In practice, the value a cap rate is quoted on is often the purchase price on a transaction, and the appraised value on a refinance.
The rate compresses several judgments into one number: how durable the income is, how much it is expected to grow, how liquid the asset is, and what return an investor demands for the risk. A brand-new industrial building leased for fifteen years to an investment-grade tenant in a supply-constrained market trades at a low cap rate because the income is close to bond-like. A 1980s suburban office building with three years of average lease term trades at a high one, because the income may not survive the hold period.
Because value equals NOI divided by cap rate, small movements in the rate move value dramatically, and non-linearly. Going from a 5% to a 6% cap rate is a 100 basis point change that destroys 16.7% of value. Going from 8% to 9%, the same 100 basis points, destroys 11.1%. Compression and expansion hurt low-cap-rate assets far more, which is why prime assets fall hardest when rates rise.
The most important practical warning is that a cap rate is only as meaningful as the NOI it is computed on. A broker quoting a 6.5% cap rate on a seller's un-normalized NOI and an underwriter computing 5.9% on a normalized one are describing the same building at the same price. Before comparing cap rates, confirm both were built on the same income definition: in-place or stabilized, with or without a management fee and reserve.
Worked example
An industrial property produces $700,000 of stabilized net operating income. Comparable sales in the submarket have traded between a 6.0% and a 6.5% cap rate. The buyer wants to understand the value range and the sensitivity to a shift in the market.
| Step | Calculation | Result |
|---|---|---|
| Value at a 6.0% cap rate | $700,000 ÷ 0.060 | $11,666,667 |
| Value at a 6.5% cap rate | $700,000 ÷ 0.065 | $10,769,231 |
| Spread across the 50 basis point range | $11,666,667 − $10,769,231 | $897,436 |
| Value if cap rates expand to 7.5% by exit | $700,000 ÷ 0.075 | $9,333,333 |
Half a percentage point of cap rate (the width of an ordinary comparable set) is worth nearly $900,000 on this asset, roughly 7.7% of value. If cap rates expand by 150 basis points to 7.5% during the hold and income has not grown, the property is worth $9.33 million against an entry value of $11.67 million: a 20% decline with a fully occupied, perfectly performing building. This is why exit cap rate assumption is the single most consequential line in most underwriting models.
Typical ranges
| Asset profile | Relative cap rate | Why |
|---|---|---|
| Single-tenant net lease, investment-grade, long term | Lowest | Income approaches bond-like certainty. |
| Stabilized multifamily, primary market | Low | Deep liquidity and reliable demand. |
| Modern industrial, strong submarket | Low | Structural demand and limited supply. |
| Grocery-anchored retail | Moderate | Resilient anchor with shop-space rollover risk. |
| Suburban office with short lease term | High | Rollover risk and uncertain re-leasing economics. |
| Hospitality | Highest | Revenue reprices nightly and is cycle-sensitive. |
How it compares
| Metric | Formula | Perspective |
|---|---|---|
| Cap Rate | NOI ÷ Value | The asset's unlevered yield at that price. |
| Debt Yield | NOI ÷ Loan Amount | The lender's yield on its exposure. |
| Cash-on-Cash | Pre-tax cash flow ÷ Equity invested | The equity investor's first-year cash return, after financing. |
| Yield on Cost | Stabilized NOI ÷ Total Cost | The developer's yield on what was actually spent. |
Common mistakes
- Comparing cap rates computed on different NOI definitions
- A trailing-twelve cap rate and a forward stabilized cap rate on the same asset can differ by more than a full percentage point.
- Believing a higher cap rate means a better deal
- It usually means the market has priced in risk (short leases, weak submarket, deferred maintenance) that the buyer will have to manage.
- Applying a cap rate to income that includes one-off items
- Capitalizing a non-recurring payment multiplies a one-time amount into permanent value that will not be there at resale.
- Using a cap rate on a property in lease-up
- Direct capitalization assumes stabilized income. A transitional asset is valued by discounted cash flow, with the cap rate applied only at the stabilized exit.
Frequently asked questions
- What is a good cap rate?
- There is no universally good cap rate, because the figure prices risk rather than measuring quality. A low cap rate indicates a high price for durable income, while a high one compensates for risk such as short lease term, a weak submarket or an operationally intensive asset. The relevant comparison is always against recent trades of genuinely similar assets in the same submarket.
- Is a higher or lower cap rate better?
- It depends on which side of the transaction you are on. A seller wants a low cap rate, because value equals income divided by the rate, so a lower rate means a higher price. A buyer seeking current yield wants a higher one, while accepting the risk that produced it.
- How do you calculate value from a cap rate?
- Divide net operating income by the cap rate. A property producing $700,000 of NOI valued at a 6.0% cap rate is worth $700,000 ÷ 0.06, or $11,666,667.
- What is the difference between cap rate and return on investment?
- A cap rate is unlevered and describes the property at a point in time: income divided by price, with no financing involved. Return on investment accounts for the investor's actual equity, the debt used, income growth over the hold and the sale proceeds at exit.