Glossary
Capitalization Rate (Cap Rate)
A capitalization rate (cap rate) is a property's net operating income divided by its value or purchase price. It expresses the unlevered annual return an investor would earn if NOI stayed constant, and it is the most common shorthand for pricing income-producing real estate.
Formula
Example
An apartment building generates $500,000 of NOI and is offered at $8,000,000. Cap rate = $500,000 / $8,000,000 = 6.25%. Working in reverse, if comparable sales trade at a 6.50% cap rate, the implied value is $500,000 / 0.065 = about $7,692,000, which suggests the asking price is roughly $308,000 above what the market supports for that income.
How it is used in underwriting
Underwriters use cap rates in both directions. Dividing NOI by price shows the going-in yield on an acquisition; dividing NOI by a market cap rate produces a value estimate, which is how appraisers apply the direct capitalization approach and how lenders check that collateral supports a loan. Cap rates are also used to estimate sale proceeds at the end of a hold through the exit cap rate. Because value is NOI divided by the cap rate, small changes have large effects: a move from 6.0% to 6.5% reduces value by about 7.7% with no change in income.
Cap rates reflect perceived risk and growth. Lower cap rates usually indicate stronger locations, better tenants, longer leases or expected income growth, while higher cap rates signal more risk or weaker growth. A common mistake is applying a market cap rate to NOI that is calculated differently from the comparables, for example before reserves or with below-market management fees. Another is treating cap rate as total return; it ignores appreciation, financing and capital spending. In business valuation, the analogous concept is an earnings yield, the inverse of a multiple.
Typical benchmarks
No single benchmark applies: cap rates move with interest rates, property type, location and tenant quality. Underwriters typically compare against recent sales of similar assets in the same submarket and against the spread over long-term Treasury yields.
Run the numbers: Cap Rate Calculator
Frequently asked questions
What is a good cap rate?
There is no universally good cap rate. A lower cap rate means a higher price relative to income, which buyers accept for lower-risk, higher-growth assets. A higher cap rate means more current income per dollar invested but usually more risk. The right cap rate is one consistent with comparable sales and with the asset's risk profile.
Is a higher cap rate better?
A higher cap rate gives more income per dollar of purchase price, which is better for a buyer if the risk is priced correctly. But high cap rates often reflect weaker locations, shorter leases or deferred maintenance. Sellers prefer lower cap rates because they mean a higher sale price for the same NOI.
How do interest rates affect cap rates?
Cap rates tend to rise when interest rates rise, because buyers using debt need higher yields to maintain returns and alternative investments become more attractive. The relationship is not one to one, since expected rent growth and capital availability also matter, but rising borrowing costs usually put upward pressure on cap rates and downward pressure on values.
Related terms
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