Cap rates,
decoded.

What is a cap rate?

A cap rate (capitalization rate) is a commercial real estate property's annual net operating income divided by its purchase price, expressed as a percentage. It is the unlevered year-one yield — what the property would return in cash flow if you bought it for all cash and held it for one year with no debt, no reserves, no tax, and no changes.

The formula is trivially simple and that is part of the problem. A number this easy to calculate gets overused as a decision rule. A cap rate is a fast comparable across similar properties; it is not a measure of return, not a measure of risk, and not by itself a basis for pricing a deal.

The formula

Cap Rate = NOI ÷ Purchase Price

A property with $200,000 of NOI priced at $3,000,000 has a cap rate of 6.67%. A property with $350,000 of NOI priced at $5,000,000 has a cap rate of 7.00%. The 7.00% property does not necessarily return more to the investor — that depends on financing, tax treatment, and appreciation assumptions. Cap rate is one input, not an answer.

What does cap rate actually tell you?

Three useful things:

1. Current income yield on property. Cap rate quantifies the income-to-price ratio at a given moment. Useful for comparing similar properties in the same submarket.
2. Relative risk pricing. All else equal, a higher cap rate means the market is demanding more yield — typically for more risk. Higher cap rate on one deal vs. another is a prompt to ask: \"what risk does this yield compensate for?\"
3. Implied valuation. Applied to projected stabilized NOI, a cap rate is used to estimate future value. This is the basis of every exit assumption in CRE underwriting.

What cap rate doesn't tell you

• Your actual return. Cap rate is unlevered. Your cash-on-cash return after debt service depends on financing terms and leverage.
• Appreciation. Cap rate ignores value growth, the largest long-term source of return for most CRE investors.
• Tax treatment. Depreciation, 1031 deferral, interest deduction — all of this sits below the cap rate calculation.
• Capital expenditure. Reserves and near-term capex are not in the cap rate. A 7% cap on a property with $500K of deferred roof replacement is not really a 7% cap.
• Tenant risk. Two properties with identical 6% caps but very different tenant credit have very different risk profiles.

What is a good cap rate?

There is no universal answer. Cap rates vary by asset class, market, tenant quality, lease term, and interest-rate environment. As a rough guide for 2026:

• Institutional multifamily, primary markets: 4.5% to 5.5%
• Value-add / Class B multifamily: 5.75% to 7.25%
• Single-tenant absolute NNN, investment-grade tenant, long term: 5.25% to 6.25%
• Single-tenant NNN, non-investment-grade, short-mid term: 7% to 9%
• Industrial, primary markets: 5.0% to 6.5%
• Self-storage, secondary markets: 6% to 7.5%
• Suburban office, Class A: 7% to 9%+

These are approximations; every deal is context-specific. Compare a candidate property against recent comparable sales in its specific submarket, not against a national average.

Going-in, stabilized, and exit cap rates

Three cap-rate flavors show up in underwriting:

Going-in cap rate

The cap rate calculated from actual or T-12 NOI at purchase. This is the number in the offering memorandum. It reflects current performance — useful as a base case.

Stabilized cap rate

The projected cap rate after lease-up, renovation, or rent push. This appears in pro forma projections and is often the seller's pitch (\"at stabilization, this is a 7.5% cap\"). Stabilization assumes execution; always underwrite the path, not just the endpoint.

Exit cap rate

The cap rate assumed at sale in underwriting, applied to projected stabilized NOI to estimate sale proceeds. Exit cap movement is the single largest source of underwriting error. A conservative underwrite uses an exit cap 25-50 basis points higher than the going-in cap to account for cap rate expansion risk and to reduce exit-proceeds sensitivity.

The exit-cap-movement stress test

Ask what happens to your IRR if exit cap moves 50, 75, and 100 basis points higher than underwriting. If a 75-bp exit-cap move swings your IRR from 15% to 5%, the deal has thin margin and is highly sensitive to market conditions at sale.

How do cap rates move with interest rates?

Cap rates and interest rates are correlated but not lockstep. The relationship works through two channels:

• Discount rate channel. Real estate competes for capital against bonds. When Treasury yields rise, investors demand higher returns from real estate, pushing cap rates up (and values down). This effect is faster in public REIT markets, slower in private CRE.
• Financing channel. Rising rates increase debt service, compress DSCR and debt yield, and reduce the loan proceeds available to buyers. Lower leverage availability reduces what buyers can pay, pushing cap rates up.

Counterweights exist: if rent growth expectations rise with inflation, cap rate movement can be partially offset by rising projected NOI. This is why sharp rate moves don't always translate one-for-one into cap-rate moves — but in aggregate, rising rates pressure cap rates upward.

When does a cap rate lie?

Stated NOI is wrong

Sellers sometimes understate operating expenses (missing management fees, zero replacement reserves, below-market insurance), overstate rent (including concessions, counting vacant space at market), or time-shift expenses (deferring maintenance that hits post-close). A cap rate calculated against inflated NOI is artificially low (more attractive). Recalculate against a realistic T-12 before trusting the going-in number.

Lease-up assumptions are aggressive

Stabilized cap rates assume rent growth, vacancy reductions, and operational improvements. If the assumed growth is 5% annual in a submarket running at 2%, the stabilized cap rate is fiction.

Tenant credit or lease term is misrepresented

\"Walgreens NNN, 6.5% cap\" tells you nothing unless you know the guarantor entity and remaining term. The same sign can sit on deals that should trade at 5.75% or 8%+.

Deferred capex is hidden below the line

A 6.5% cap on a property that needs $500K of HVAC and $300K of roof work in year two is really a 5.0% cap after you account for that capex. Always underwrite reserves realistically and back the number out of the implied yield.

How do you use cap rate alongside other metrics?

Cap rate should never be the sole decision metric. Pair it with:

• Cash-on-cash return (current yield on equity after debt)
• DSCR (cushion above debt service)
• Debt yield (leverage-agnostic stress test)
• IRR (total time-weighted return over hold)
• Equity multiple (total return on invested equity)
• Yield on cost (stabilized NOI ÷ all-in cost — for value-add and development)
• Price per square foot vs. replacement cost (basis safety)

Each metric highlights a different risk. Cap rate tells you entry yield. DSCR tells you debt safety. IRR tells you total return. No single metric captures the full picture.

Frequently asked questions

How do you calculate cap rate?

Cap rate = NOI ÷ Purchase Price, expressed as a percentage. NOI is annual net operating income after expenses but before debt service, depreciation, and taxes.

Why isn't cap rate the same as yield?

Cap rate is a year-one snapshot on unlevered income. Yield more commonly refers to levered cash-on-cash return or total return over a hold period. Cap rate is a narrower concept.

What is a reverse cap rate?

Not standard terminology. Some practitioners use it to describe the cap rate implied by a target price and known NOI: Implied Cap = NOI ÷ Target Price.

Does cap rate vary by location?

Yes — significantly. A Class A multifamily property in Manhattan trades at a meaningfully tighter cap rate than an identical-quality property in a Midwest tertiary market. Submarket, supply-demand dynamics, and perceived risk all drive the difference.

Can cap rate be negative?

If NOI is negative (expenses exceed income), the math produces a negative cap rate. In practice, this signals a property being purchased on a non-income basis — land, redevelopment plays, or distressed assets priced on future value.