Cap Rate (Capitalization Rate)
Cap Rate Formula
For example, a property generating $120,000 in annual NOI with a market value of $1,500,000 has a cap rate of 8.0%. This tells you that, before financing costs, the property yields 8% on its purchase price.
What the Cap Rate Tells You
The cap rate is essentially a snapshot of unlevered yield — what you’d earn if you bought the property entirely with cash. It strips out financing, so it’s useful for comparing properties on an apples-to-apples basis regardless of how each deal is structured.
Think of it as the real estate equivalent of an earnings yield on a stock. Just as you might compare the P/E ratio across companies, you compare cap rates across properties.
Typical Cap Rates by Property Type
| Property Type | Typical Cap Rate Range | Risk Profile |
|---|---|---|
| Class A Multifamily (Major Metro) | 4.0% – 5.5% | Low risk, stable demand |
| Class B/C Multifamily | 5.5% – 7.5% | Moderate risk, value-add opportunity |
| Office (CBD) | 5.0% – 7.0% | Moderate — tenant concentration risk |
| Industrial / Logistics | 4.5% – 6.5% | Low-to-moderate, strong tailwinds |
| Retail (Strip Mall) | 6.0% – 8.5% | Higher risk — e-commerce headwinds |
| Hotel / Hospitality | 7.0% – 10.0% | High risk, cyclical |
Cap Rate vs. Cash-on-Cash Return
| Feature | Cap Rate | Cash-on-Cash Return |
|---|---|---|
| Formula | NOI ÷ Property Value | Pre-Tax Cash Flow ÷ Total Cash Invested |
| Includes financing? | No — unlevered | Yes — accounts for mortgage payments |
| Best used for | Comparing properties regardless of financing | Evaluating actual return on your equity |
| Leverage impact | None | Higher with more leverage |
Factors That Influence Cap Rates
Interest rates. When interest rates rise, cap rates tend to follow. Higher borrowing costs reduce what buyers can pay, which pushes prices down and cap rates up.
Location and property quality. Prime locations and high-quality assets command lower cap rates because investors accept lower returns for lower risk. A Class A apartment building in Manhattan will always trade at a lower cap rate than a strip mall in a secondary market.
Tenant quality and lease terms. Long-term leases with creditworthy tenants reduce risk, which compresses cap rates. A warehouse leased to a Fortune 500 company for 10 years has a very different risk profile than a multi-tenant retail center with month-to-month leases.
Market supply and demand. When too much capital chases too few deals, cap rates compress. When credit tightens or investor sentiment shifts, cap rates expand.
Key Takeaways
- Cap rate = NOI ÷ Property Value — it measures unlevered return on a real estate investment.
- Higher cap rates mean higher expected returns but also higher risk.
- Cap rates vary significantly by property type, location, and market conditions.
- It’s best used for comparing properties, not as a standalone investment decision tool.
- Always verify the NOI assumptions behind a quoted cap rate — garbage in, garbage out.
Frequently Asked Questions
What is a good cap rate for an investment property?
It depends on the market and property type. Generally, 5% to 8% is considered a solid range for most commercial properties. Class A assets in major metros may trade at 4-5%, while value-add or higher-risk properties might offer 8-10%.
Does a higher cap rate mean a better investment?
Not necessarily. A higher cap rate reflects higher perceived risk. A 10% cap rate property might have high vacancy, deferred maintenance, or be in a declining market. Always investigate why the cap rate is high before assuming it’s a bargain.
How do interest rates affect cap rates?
Rising interest rates generally push cap rates higher because borrowing becomes more expensive, reducing what buyers can pay. This compresses property values. Falling rates have the opposite effect — they compress cap rates and boost prices.
What’s the difference between cap rate and ROI?
Cap rate measures the property’s unlevered, annual income yield. ROI captures the total return including appreciation, tax benefits, and the effect of financing over the entire holding period. Cap rate is a snapshot; ROI is the full picture.
Can you use cap rate for residential properties?
Cap rates are primarily used for commercial and multi-family properties. For single-family homes, investors more commonly use cash-on-cash return or gross rent multiplier because the scale of a single unit makes NOI-based analysis less meaningful.