The capitalization rate, or cap rate, is a property's net operating income divided by its price or value. A building that earns 650,000 of NOI and sells for 10,000,000 trades at a 6.5 percent cap rate.
It is the quickest way to put buildings of different sizes on one scale, and it works in both directions: divide NOI by a cap rate to get a value, or divide NOI by a price to see the rate the market paid.
How it is calculated
Cap rate = NOI ÷ price. The income approach reverses it: value = NOI ÷ cap rate. Because the relationship is proportional, a change in the NOI moves the value by the same percentage, and a half-point change in the rate moves it far more at a low rate than at a high one.
What moves a cap rate
- Risk and growth expectations. Lower rates go with stable income and expected growth; higher rates go with risk, short leases or a weak location.
- Interest rates and the cost of capital. When debt gets more expensive, buyers usually want a higher yield, and rates tend to follow.
- Property type and market. Multifamily, industrial, retail and office carry different rates, and the same type differs between markets.
- Which NOI. The same price gives different cap rates on in-place NOI, trailing NOI and a pro forma. Always ask which one was used.
Where cap rates mislead
A cap rate says nothing about how much capital the building will need, how long the leases run, or what the debt costs. Two buildings at the same rate can be very different investments. It is also a snapshot: it ignores growth, so it understates a building whose rents are rising and flatters one whose rents are falling.
The rate is only as comparable as the NOI behind it. If one figure deducts reserves, leasing costs and a management fee and the other does not, the two rates are not the same measurement.