What Is a Cap Rate?
In commercial real estate (CRE), one of the most common metrics you’ll hear is the capitalization rate, or “cap rate.” At its simplest, the cap rate measures the expected return on an investment property, based solely on the income it generates.
It’s a quick way for investors to compare opportunities and evaluate whether a property is priced appropriately for the risk involved.
How Cap Rates Are Calculated
The formula is straightforward:
Cap Rate = Net Operating Income (NOI) ÷ Current Market Value (or Purchase Price)
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Net Operating Income (NOI): Rental income minus operating expenses (but before financing and taxes).
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Market Value or Price: The property’s current market price or acquisition cost.
Example:
If a building generates $500,000 in NOI and is valued at $10,000,000:
Cap Rate = $500,000 ÷ $10,000,000 = 5%
What Cap Rates Reveal (and What They Don’t)
Cap rates are useful, but they aren’t the whole story. Here’s what they tell you:
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Return Potential: Higher cap rates usually mean higher potential returns.
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Risk Assessment: Lower cap rates often suggest lower risk (prime locations, stable tenants), while higher cap rates suggest more risk (emerging markets, shorter leases).
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Market Trends: Cap rates shift with interest rates, local demand, and investor sentiment.
👉 But remember: Cap rates do not factor in financing, tax strategy, or future appreciation.
High vs. Low Cap Rates: Which Is Better?
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Low Cap Rate (3–6%): Typically found in core markets with stable tenants and strong demand. Lower returns, but lower risk.
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High Cap Rate (7–10%+): Often in secondary or tertiary markets, or properties needing improvements. Higher returns, but also higher risk.
Neither is inherently better—it depends on your investment goals and risk tolerance.
How Investors Use Cap Rates
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Comparing Properties: Cap rates make it easy to evaluate two similar assets in different markets.
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Valuing Properties: Investors often back into a property’s value by applying market-based cap rates to projected NOI.
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Formula: Value = NOI ÷ Cap Rate
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Analyzing Risk: Cap rates help you understand how the market perceives risk for a given property type or location.
Limitations of Cap Rates
While useful, cap rates shouldn’t be the only metric you rely on. They don’t account for:
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Future rent growth or market appreciation.
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Financing costs or leverage strategies.
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Tenant creditworthiness or lease structures.
Cap rates should be combined with other tools like cash-on-cash return, IRR (internal rate of return), and market analysis for a full picture.
Final Takeaway: Smarter Investing with Cap Rates
For beginner CRE investors, understanding cap rates is the first step toward smarter investing. They’re a simple, powerful way to evaluate opportunities—but they’re not the whole story. By using cap rates alongside other financial metrics and market insights, you’ll make better-informed, more profitable decisions.
📌 Want help analyzing cap rates and investment opportunities? Contact our team for expert guidance in building your commercial real estate portfolio.
✅ SEO Opportunities & Internal Links
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Blog link: “What Investors Should Know Before Buying Commercial Property”
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Blog link: “How to Build a Diversified Commercial Real Estate Portfolio”
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Service page: “Commercial Investment Advisory Services”