The cap rate (capitalization rate) is one of the most widely used metrics in commercial real estate because it helps investors estimate potential returns and compare different properties quickly.
More than that, it gives insight into the relative risk of an investment.
In this guide, we’re breaking down what cap rate in real estate means: how they’re calculated, why they matter, and how to use them effectively in your decision-making process.
What is a cap rate in real estate?
Real estate cap rate indicates a property’s net operating income (NOI) against its market value or purchase price.
It reflects the expected return on an investment over a one-year period assuming no debt is involved.
Here’s the formula investors use when calculating the cap rate for real estate:
Cap Rate = Net Operating Income / Property Value
The result is expressed as a percentage and gives you a clear snapshot of how much income the property is projected to generate compared to its value. It can help you estimate investment returns and evaluate purchase opportunities.
All that said, a property’s cap rate doesn’t necessarily show the complete picture because it doesn’t consider factors like financing, the time value of money, or future income from renovations or other improvements.
So while it’s a useful metric, you have to use it as part of a more comprehensive financial analysis.
Related blog: The Difference Between Cap Rate and ROI
Why are cap rates so important?
Cap rates help investors and appraisers evaluate value and return across a wide range of properties.
- Benchmark for pricing: Real estate cap rate helps you assess whether the CRE property you are interested in is priced fairly compared to similar CRE assets in the market.
- Risk indicator: Cap rates can help you assess how risky a certain commercial property is. A higher cap rate generally suggests a higher potential return, but also more risk. If a property’s cap rate is significantly above others in the same market, watch out — its vacancy rates could be high, the lease terms might be short or unstable, or the tenants may be less creditworthy or inconsistent with payments.
- Estimate of return: Investors often refer to the cap rate of real estate to estimate the annual return on a property before financing. Lower cap rates typically suggest stable, lower-risk assets with steady cash flow. Higher cap rates might indicate more risk but also greater upside — if managed well.
- Comparison tool: Cap rates make it easier to evaluate multiple properties side by side. Whether comparing similar asset types or different markets, cap rates provide a standardized measure for analyzing relative value.
Aside from being useful for CRE investors, cap rates are also relied on by lenders and appraisers who want to determine what a property is worth based on how much income it generates.
They take the property’s NOI and divide it by the cap rate to calculate its income-based value and assess loan collateral or set a market price.
Factors that influence cap rates
- Property type and quality: High-quality assets like Class A office buildings usually have lower cap rates due to lower risk and stronger performance outlooks, while older or more specialized buildings tend to carry higher cap rates. Multifamily and industrial properties have recently recorded some of the lowest cap rates because of high occupancy rates and stable rental income, as well as consistent tenant demand in both sectors.
- Location and market dynamics: Properties in central business districts or high-demand urban areas generally have lower cap rates because they generate a stable income. Secondary and tertiary markets typically carry higher cap rates partly due to increased uncertainty around demand and tenant turnover. Proximity to job centers and transit hubs as well as major highways can also affect a property’s marketability real estate cap rate.
- Lease structure and tenant credit: Long-term leases with creditworthy tenants reduce income volatility and push cap rates lower. In contrast, properties with frequent vacancies or short-term lease agreements tend to have higher cap rates due to increased risk. But during inflation, short-term leases (like those in apartments) can be an advantage because they allow landlords to raise rents more quickly and offset some of that added risk.
- Interest rates and capital markets: Cap rate in real estate often moves in response to changes in interest rates and market liquidity. When interest rates rise, borrowing becomes more expensive and CRE investors require higher cap rates to justify the added cost. This drives property values down. But if investors expect strong rent growth and higher net operating income, they may still accept lower cap rates despite rising rates.
Cap rates usually rise when the economy is weak because fewer buyers are willing to pay premium prices and property values fall. Investors also demand higher returns to compensate for the risk of slower rent growth and higher vacancies that cause unstable cash flow.
How to use cap rates when evaluating investments?
Cap rates don’t tell you everything but they can quickly flag whether a property’s price makes sense for its income. Here’s how to use them to sharpen your CRE investment decisions:
- Review market reports and recent sales data from sources like CBRE or NCREIF to understand whether a property’s cap rate is in line with market averages and similar assets.
- Check how reliable and predictable the income is. If a property has a low cap rate, make sure the income justifies it. Review rent rolls, lease terms, tenant quality, and market demand. A low cap rate signals that the property is priced as if the income is stable and dependable, but if the rent stream looks uncertain due to short leases, weak tenants, or market volatility, the pricing may not reflect the actual risk, and you could be overpaying.
- Run exit scenarios using different cap rates. Don’t rely on a single projected exit cap when modeling your returns. Plug in a range (higher and lower) and see how each affects your sale price and IRR. This will help you test whether your assumptions hold up and whether the deal still works if the market softens or NOI changes.
- Don’t rely on cap rates alone. Compare them with other key metrics like internal rate of return (IRR) and cash-on-cash return. Run all three side by side to see how the property performs over time, how much cash it puts in your pocket, and whether the projected returns justify the risk.
Common misconceptions about cap rates
Commercial real estate cap rates are often misunderstood. Here are some misconceptions that may distort your analysis and lead you to make poor CRE investment decisions.
Misconception: Cap rate equals total return
This isn’t accurate. Cap rate in real estate reflects current income relative to property value — it doesn’t include appreciation or tax benefits.
Relying solely on this number can oversimplify your analysis. To get a full picture, combine cap rate insights with a property inspection, market research, and forward-looking financial projections.
Misconception: Lower cap rate always means a better investment
Not necessarily. A low cap rate usually means you’re paying a premium for a property with stable income, which results in a lower initial return. That doesn’t guarantee safety or long-term profitability.
On the flip side, a high cap rate might mean more income but also more risk (like poor location, weak tenants, or high vacancies).
The “right” cap rate depends on your risk tolerance and investment goals, and also largely on the specific CRE asset. In many cases, a mid-range cap rate on a well-located and stable property delivers better value over time than a higher cap rate on a distressed one.
Misconception: Cap rates never change
Cap rates are tied to market conditions and can shift over time. Different factors — from income levels and demand to interest rates and overall investor sentiment — can influence cap rate movement. As such, the rate calculated at acquisition may become outdated, so reassess it periodically.
Conclusion
Need support analyzing a deal or structuring financing around cap rate targets? Contact our team of stated income commercial lenders at Private Capital Investors. Call 972-865-6206 or email info@privatecapitalinvestors.com to get expert advice for your next commercial acquisition.
Sources
- https://www.pnc.com/insights/personal-finance/borrow/what-is-cap-rate.html#:~:text=Why%20Cap%20Rates%20Are%20Important,lower%20risks%20and%20potential%20rewards.&text=consider%20a%20range%20of%20profitability,in%20addition%20to%20cap%20rates.
- https://www.investopedia.com/terms/c/capitalizationrate.asp#:~:text=The%20cap%20rate%20is%20the,and%20unlevered%20rate%20of%20return.
- https://www.jpmorgan.com/insights/real-estate/commercial-term-lending/cap-rates-explained
- https://fnrpusa.com/blog/an-introduction-to-cap-rates-in-commercial-real-estate/?utm_term=blog%2Ban-introduction-to-cap-rates-in-commercial-real-estate
