Cap Rates Explained: A Practical Guide
The capitalization rate is one of the most-cited metrics in commercial real estate — and one of the most-misunderstood. Cap rate is a useful tool, but only when you know what it includes, what it excludes, and how lenders use it.
The Formula
Cap rate equals net operating income divided by property value. A property generating $100,000 in NOI valued at $1,250,000 has an 8% cap rate. NOI excludes debt service and capital expenditures — it is the property's pre-financing yield.
What It Tells You
Cap rate provides a quick yield comparison across properties. A 6% cap is roughly equivalent to buying any asset that yields 6% — adjusted for risk, growth, and tax treatment.
What It Does Not Tell You
Cap rate ignores financing. Two investors buying the same property at an 8% cap will earn very different cash-on-cash returns depending on leverage. Cap rate also assumes stabilized NOI — a property in transition has a misleading current cap rate.
Cap Rate Compression and Expansion
When market cap rates compress (drop), values rise — even with no change in NOI. When cap rates expand (rise), values fall. Understanding the cap rate environment is as important as understanding the property itself.
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