Cap Rates

(Capitalization Rate)

“The Shorthand Read on Comm’l Property”

Capitalization Rate (Cap Rate): Connecting Income, Value, and Risk

A Capitalization Rate (Cap Rate) is a simple but powerful metric in commercial real estate finance that connects income, value, and risk in one simple formula.  

 

Cap Rates sit in a peculiar spot of being simple and straightforward on the surface, but also possess a nuanced complexity.

(more on that below)

The Core Definition

A Capitalization Rate (Cap Rate) is the ratio of a property’s Net Operating Income (NOI) to its Current Market Value.

 

Formula (Definition):

Cap Rate = Net Operating Income (NOI) ÷ Current Market Value

  • NOI = Property’s annual income after operating expenses (before debt service & taxes).
  • Current Market Value = What the property could be bought or sold for in today’s market.

Example Calculation

A property generates $400,000 in NOI and has a market value of $6,000,000, the cap rate would be:

Cap Rate = $400,000 / $6,000,000 = 6.67% (0.0667)

 

This single number expresses the annual return an investor would earn if the property were purchased entirely with cash. 
It’s a yield metric — telling you how much income (as a %) a property produces relative to what it’s worth in the market.

Interpreting Cap Rates

  • Lower Cap Rate (e.g., 4%–5%) → Property trades at a higher price for the same NOI (perceived as lower risk).
  • Higher Cap Rate (e.g., 7%–9%) → Property trades at a lower price for the same NOI (perceived as higher risk).

Cap rates vary by:

  • Property Type (office, retail, industrial, multifamily, hotel).
  • Location Quality (prime metro vs. secondary market).
  • Tenant Strength & Lease Term (strong credit tenants and long leases push cap rates down).
  • Market Conditions (interest rates, investor demand, and risk appetite).

Cap rates are useful for:

  • Comparing Investments: They allow investors to compare the potential returns of different properties quickly.
  • Assessing Risk: A higher cap rate typically indicates higher risk and potential reward, while a lower cap rate suggests lower risk.

How It Connects the Dots

  • Income → The starting point is NOI, a property’s recurring income after operating expenses.
  • Value → Investors apply market-based cap rates to NOI to determine what a property is worth today.
  • Risk → Cap rates shift up or down depending on how the market perceives stability and uncertainty.

Put simply: higher risk = higher cap rate = lower property value;       lower risk = lower cap rate = higher property value.

Example 1: Prime Retail Store (Downtown Location)

  • NOI: $750,000

  • Market Value: $15,000,000

  • Cap Rate:  750,000 ÷ 15,000,000 = 5%

 

💡 What It Means

  • A low cap rate (5%) shows investors are willing to accept a smaller yield because they see this property as low risk.

  • Factors driving this include:

    • Prime location in a thriving downtown core.

    • Strong tenant(s) such as national retail chains with long-term leases.

    • Stable cash flow with minimal vacancy risk.

 

👉 Takeaway: For owners, this means the property is highly valuable relative to its income — the market is rewarding stability with a premium valuation. For investors, it’s a “safe-bet” asset, but with lower returns.

Example 2: Suburban Office Building

  • NOI: $600,000

  • Market Value: $8,000,000

  • Cap Rate:  600,000 ÷ 8,000,000 = 7.5%

 

💡 What It Means

  • A higher cap rate (7.5%) signals that buyers demand more return for the risks they perceive.

  • Risk drivers could include:

    • Location risk — a suburban office park with weaker demand compared to downtown.

    • Tenant rollover — leases expiring soon, uncertainty about renewals.

    • Market headwinds — shifting demand for office space in a post-hybrid work environment.

 

👉 Takeaway: Owners may face lower valuations even if cash flow is solid. Investors are pricing in the uncertainty by requiring a higher yield.

(with respect to the above examples):

Cap Rate Compression (5%) = Stability, liquidity, and long-term investor demand.

Cap Rate Expansion (7.5%) = Higher risk, uncertainty, or weaker demand.

Interpreting Cap Rates:

Expanded Utilization

  • Snapshot Yield → What’s the one-year return today?

  • Risk Thermometer → How safe or risky is the market judging it?

  • Pricing Shortcut → How do I back into property value quickly?

  • Market Benchmark → How does this deal compare to others?

Snapshot Yield

A cap rate shows the one-year return an investor would earn if the property were purchased entirely with cash.

  • It’s a quick way to see how much income the property generates relative to its price.

Example:
If a property generates $500,000 NOI and is worth $10,000,000, the cap rate is 5%.
★ That means the investor is effectively earning a 5% annual return on the purchase price.

 

Risk Thermometer

A cap rate is like a market risk gauge.

  • Lower cap rates = investors perceive less risk (prime locations, strong tenants, stable income).
  • Higher cap rates = investors demand more return to take on more risk (secondary markets, short leases, volatile income).

Example:
A downtown office tower might trade at a 4.5% cap, reflecting stable tenants and high demand.
A suburban office park could trade at an 8% cap, signaling investors want a higher return because of lease rollover risk.
★ Think of it as the property’s “interest rate” set by market perception.

 

Pricing Shortcut

A cap rate is the market’s shortcut to property value.

  • It lets investors translate income (NOI) into today’s price without needing a full discounted cash flow model.

Example:
If market comps show 6% cap rates for neighborhood retail centers, and your NOI is $600,000, then:

Value = NOI ÷ Cap Rate = 600,000 ÷ 0.06 = $10,000,000

★ With just NOI and the market cap rate, you can back into property value instantly.

 

Market Benchmark

Cap rates act as a benchmark between asset classes and geographies.

  • They let you compare where your money works harder.

Example:

  • Industrial warehouse at 5.5% cap → NOI $1,100,000 → Value $20,000,000.
  • Retail center at 7% cap → Same NOI $1,100,000 → Value $15,714,000.

★ The same income is valued differently, so cap rates let you weigh risk-adjusted return across asset types.

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The Double Nature of Cap Rates (the Simplicity/Complexity duality)

The Simplicity

  • One clear formula: Cap Rate = NOI ÷ Market Value.
  • Quick read: Tells you the property’s yield today, no spreadsheets required.
  • Easy comparison: Lets you benchmark assets side-by-side across markets and property types.

✪ This is why brokers, bankers, and owners love to quote cap rates — they provide instant clarity.

The Nuanced Complexity

  • NOI isn’t always “clean”: What’s included (or excluded) in operating expenses can shift NOI.
  • Market value is subjective: Comparable sales, investor appetite, and financing conditions drive pricing, which then drives the “cap rate.”
  • Dynamic with risk: Cap rates compress or expand with tenant strength, lease length, location, and macroeconomic factors (like interest rates).
  • Not future-proof: Cap rate is a snapshot, not a forecast — it doesn’t model growth, rent escalations, or vacancies.

✪ Beneath the simplicity, interpreting cap rates properly requires judgment and market context.

💡 Bonus: Cap Rates Quick Reference Table*

Property TypeTypical Cap Rate RangeRisk ProfileNotes
Prime Office (Class A, Core Market)4% – 5.5%LowStrong tenants, trophy locations, stable demand.
Suburban / Secondary Market Office6% – 8%MediumHigher vacancy risk, less liquidity.
Retail – Grocery Anchored / Core Urban4.5% – 6%LowEssential services, resilient tenant mix.
Retail – Power Centers / Secondary Locations6.5% – 8.5%Medium–HighTenant turnover, e-commerce headwinds.
Industrial / Logistics (Core Markets)5% – 6.5%Low–MediumStrong demand from e-commerce; often competitive pricing.
Industrial / Flex / Secondary Market7% – 9%Medium–HighOlder facilities, niche tenants.
Multifamily – Urban Class A4% – 5.5%LowHigh demand, stable cash flows, competitive pricing.
Multifamily – Suburban / Class B-C6% – 8%MediumDependence on local employment trends.
Hospitality / Hotels (Urban Core)7% – 9%HighIncome tied to tourism, highly cyclical.
Specialty / Single-Tenant (NNN Leases)5% – 7%Low–MediumHeavily dependent on tenant creditworthiness.

*Cautions in Using Cap Rate Tables

Cap rate ranges are helpful benchmarks but not absolute truths. A few cautions:

  1. Market-Specific:
    A “retail cap rate” in downtown Manhattan could be 4.5%, while in a tertiary Midwest city it might be 8%. Tables often average across broad categories.
  2. Asset Quality:
    Cap rates depend heavily on tenant quality, lease terms, and building condition. A fully leased grocery-anchored center trades much lower than a strip center with vacancies.
  3. Timing:
    Cap rates shift quickly with interest rates, capital flows, and risk sentiment. A 6% suburban office cap in 2021 might now be 8%+ in 2025.
  4. Not a Full Valuation Tool:
    Cap rates only measure current NOI, ignoring future rent growth, lease rollover, capital expenditures, or redevelopment potential.
  5. Blended Ranges:
    “Quick reference” tables are broad generalizations — they’re best used as a first-pass screen or discussion tool, not as a substitute for market-specific comps.