Cap rate (short for capitalization rate) is a property’s annual net operating income divided by its price: the return the building would produce in one year if you bought it outright with cash and no debt.
How Is a Cap Rate Calculated?
The formula is simple division:
Cap rate = net operating income (NOI) ÷ purchase price
NOI is what the property earns after operating expenses like taxes, insurance, payroll, and maintenance, but before any loan payments.
For example: a $1 million property producing $50,000 of NOI trades at a 5% cap rate, because $50,000 divided by $1 million is 5%. Run the formula backward and it becomes a valuation tool: at a 5% market cap rate, $50,000 of NOI supports a $1 million price.
Two conditions are built into the definition, and both get ignored constantly:
- Cap rate only applies to stabilized properties. Stabilized means occupancy and rents near the market average, with no deferred maintenance. A half-empty building, or one renting at half the going rate, can’t be valued on a spot cap rate.
- Cap rate ignores debt. It’s an unlevered number. Add a loan and your actual return on invested cash becomes cash-on-cash return, a different metric that moves with your financing.
The Boardwalk Take
The cap rate is the most abused metric in commercial real estate, and it’s nothing more than a measure of value at a moment in time. That’s it. A higher cap rate isn’t a better deal; it’s the market telling you the asset carries more risk, and after all the cap rate talk, nearly every deal still gets priced off comps anyway.
Read more: The Cap Rate Is Dead, Long Live the Cap Rate!
Frequently Asked Questions About Cap Rates
How is cap rate calculated?
Divide a property’s annual net operating income by its purchase price. A property with $50,000 of NOI bought for $1 million has a 5% cap rate. The cap rate is the unlevered yield: what the building itself earns before any financing.
Is a higher cap rate better?
It depends. A higher cap rate can reflect higher risk, but in a distressed market it can also signal a buying opportunity. The number in isolation is meaningless; what matters is the asset quality, location, and story behind it.
If a double-digit cap rate looks too good to be true, it probably is.
Why do cap rates only apply to stabilized properties?
Because the formula assumes the current NOI is representative. A property with heavy vacancy, below-market rents, or deferred maintenance doesn’t have a representative NOI yet, so a spot cap rate misprices it. Unstabilized assets get valued on a multi-year cash flow model and comps instead.
Disclaimer: This blog post is for educational and informational purposes only and does not constitute investment, tax, legal, or accounting advice.