A cap rate (capitalization rate) is a property’s annual net operating income divided by its value or purchase price, expressed as a percentage. It is commercial real estate’s core pricing shorthand: the unlevered yield a buyer earns at today’s income, and the rate at which the market “capitalizes” a property’s income into a value.
The formula and what it means
Cap rate = NOI ÷ property value.
A building producing $500,000 of net operating income that sells for $10 million trades at a 5% cap rate ($500,000 ÷ $10,000,000). Rearranged, the formula values property: the same building at a 6% market cap rate would be worth $8.33 million — which surfaces the relationship every real estate investor internalizes first: cap rates and values move inversely. Rising cap rates mean falling prices for the same income; “cap rate compression” is appreciation without any income growth, and cap rate expansion is how rate cycles mark down property values, as the 2022–2024 repricing demonstrated across most sectors.
What a cap rate is not matters as much. It’s unlevered — debt and its costs appear nowhere, so it isn’t the investor’s return in a financed deal (that’s where cash-on-cash and IRR enter). It’s a snapshot at current income — no growth, no capital expenditures, no lease-up assumptions. And it’s only as honest as the NOI in the numerator: seller marketing based on projected (“pro forma”) NOI rather than actual, or NOI that understates management and reserves, manufactures a better-looking cap rate from the same building.
Reading cap rates like the market does
A cap rate is a risk price. Low cap rates mark income the market considers safe and growing — a new triple net lease property with an investment-grade tenant might trade near Treasury-adjacent levels — while high cap rates flag risk or decline: short WALT, weak tenants, secularly challenged sectors, tertiary markets. Comparing cap rates is therefore only meaningful within sector, market, and quality cohorts; a “high” cap rate is compensation, not a bargain, until diligence says otherwise.
The forward-looking cousin drives underwriting math: the exit cap rate assumed at future sale is among the most consequential assumptions in any offering’s projections — a modest 50-basis-point difference in exit cap moves terminal value enough to make or break a projected IRR. When reviewing sponsor materials, the going-in versus exit cap spread deserves a direct look: underwriting exit caps below going-in caps builds appreciation into the model by assumption, and the sensitivity analysis shows how much the deal depends on it. The same logic anchors published NAVs of non-traded real estate vehicles, where appraisal cap-rate assumptions translate directly into share values.
FAQ
What is a cap rate in simple terms?
The yield a property produces at its current income and price: annual net operating income divided by value. A $1 million property earning $60,000 of NOI is a 6% cap.
How do you calculate a cap rate?
Divide net operating income — rental income minus operating expenses, before debt payments — by purchase price or current value. Use actual, verifiable NOI, not projections.
What is a good cap rate?
There isn’t a universal one. Lower cap rates price safety and growth; higher ones price risk. A “good” cap rate is one appropriate to the property’s sector, market, tenancy, and condition — and attractive relative to comparable deals and financing costs.
Why do property values fall when cap rates rise?
Because value is income divided by the cap rate. If the market demands a higher yield for the same income stream, the price that delivers that yield is lower.
Related terms
Net Operating Income (NOI) · Exit Cap Rate · Cash-on-Cash Return · DSCR · Triple Net Lease · NAV
Educational content only; not investment, tax, or legal advice. Consult qualified professionals regarding your specific circumstances.
