The short answer
A cap rate, short for capitalization rate, is a property's net operating income (NOI) divided by its value or price. A building that earns $600,000 a year after operating expenses and is priced at $10,000,000 trades at a 6.0% cap rate. Turned around, value equals NOI divided by the cap rate.
There is no universal good cap rate. A higher one means more income for the price, usually because the buyer takes on more risk or expects less growth, so what counts as good depends on the asset, its market and the buyer. Every buyer should test how the deal holds up if the cap rate at sale is higher than the one paid today.
How to calculate a cap rate
The cap rate calculation is one line: cap rate = NOI ÷ price. For a hypothetical building with NOI of $500,000 offered at $8,000,000, the cap rate is $500,000 ÷ $8,000,000 = 6.25%. Three details decide whether the number means anything:
- Which NOI. Trailing NOI uses the last twelve months of actual results; forward NOI uses the next twelve months, projected. A cap rate quoted on projected NOI makes the same price look cheaper.
- What is in it. NOI is income after vacancy and operating expenses, before debt service, depreciation and income taxes. Whether a reserve for replacements is deducted varies, so compare like with like.
- What it leaves out. A cap rate is one year's yield before financing. It ignores debt, capital spending, lease expiries and growth, so it starts the underwriting rather than replacing it.
What drives cap rates
A cap rate is the market's price for a stream of income. Anything that makes the income riskier, or money dearer, pushes cap rates up; anything that makes it safer or likelier to grow pushes them down.
- Perceived risk. Tenant credit, vacancy, the building's age and condition, and how predictable the income is. Hotels, whose income resets every night, usually trade at higher cap rates than buildings let on long leases.
- Interest rates. Higher rates raise the cost of debt and the return available elsewhere, so buyers pay less for the same income.
- Asset type. Each property type carries its own demand, operating risk and range of cap rates.
- Location. Prime locations in large, liquid markets tend to trade at lower cap rates than the same building in a smaller market with fewer buyers.
- Growth expectations. Where rents are expected to rise, buyers accept less income today.
- Lease terms. A long lease to a strong tenant lowers the cap rate; short leases, early expiries or a weak tenant raise it.
One way to hold these together: for income expected to grow at a steady rate indefinitely, the cap rate on next year's NOI equals the return investors require minus the growth they expect. Risk and interest rates move the first term; growth moves the second.
The spread over government bonds
Investors compare property income with the safest long-term yield available, in the United States usually the 10-year Treasury. The cap rate spread is the difference between the two: the extra yield a buyer earns for owning a building, with its vacancies and repairs, instead of a government bond.
A wide spread means property is priced cheaply against bonds, or that buyers see more risk ahead. A narrow spread means property is priced richly, or that buyers expect rent growth to make up the difference. Cap rates tend to follow long-term rates, but slowly and not one for one, because property trades less often and rising rents can offset part of a rate increase. The spread tells you whether today's cap rates already reflect today's cost of money.
What is a good cap rate?
A cap rate trades income now against risk or growth later, so a good one fairly pays for the risk of the specific asset and fits the plan of the specific buyer.
- An income buyer holding a stable, well-leased building for the long term can accept a lower cap rate: the income is reliable and the asset easy to sell.
- A value-add buyer cares less about the going-in rate than about the yield on total cost: NOI after the work, divided by the price plus the cost of the work.
- A buyer using debt needs the cap rate above the loan constant, annual debt service divided by the loan, for borrowing to raise the cash return rather than dilute it.
- Every buyer should test against comparable sales in the same submarket. A cap rate well above its peers usually prices a problem; one well below assumes growth someone will have to deliver.
Be wary of national averages. A cap rate that is high for a new warehouse let to a strong tenant may be low for an aging office building with half its leases about to expire.
Going-in versus exit cap rate
The going-in cap rate is the first year's NOI divided by the purchase price. The exit cap rate, also called the terminal cap rate, is the rate assumed when the property is sold at the end of the hold, usually applied to the following year's NOI to estimate the sale price.
Underwriters usually set the exit cap rate above the going-in rate: the building will be older, its leases closer to expiry, and no one knows where interest rates will be. A common convention adds a margin, often a quarter to half a percentage point. An exit cap rate below the going-in rate assumes the market will pay more for the same income later, and it is one of the easiest ways to make a weak deal look strong.
How a small change moves value
Because the cap rate divides the NOI, small changes in it move value a long way. Here is a property with NOI of $1,000,000 valued at five cap rates:
| Cap rate | Value | Change versus 5.0% |
|---|---|---|
| 5.0% | $20.0M | Base |
| 5.5% | $18.2M | −$1.8M (−9.1%) |
| 6.0% | $16.7M | −$3.3M (−16.7%) |
| 6.5% | $15.4M | −$4.6M (−23.1%) |
| 7.0% | $14.3M | −$5.7M (−28.6%) |
The effect is steepest where cap rates are lowest. Moving from 5.0% to 5.5% takes 9.1% off the value, while moving from 6.5% to 7.0% takes about 7.1%, so the low-cap-rate assets that look safest are the most exposed to a rise. For any move, divide the old cap rate by the new one and subtract one: 5.0% ÷ 6.0% − 1 = −16.7%.
How to stress test the exit cap rate
The sale price is often a large share of the total return, so the exit cap rate deserves its own stress test.
- Set the base case above the going-in rate, for the reasons above.
- Run a range. Recompute the sale price, IRR and equity returned at the base exit cap and at least half a point and a full point higher.
- Find the break-even exit cap. Identify the rate at which you only get your equity back, and the one at which you miss your minimum return. The distance from the base case is your margin of safety.
- Check the debt. If a higher cap rate leaves the property worth less than the loan, a sale or refinance cannot repay it.
- See where the return comes from. If most of the IRR arrives with the sale, the deal depends on the exit cap rate.
Leverage magnifies the move
Take the property from the table, bought at a 5.0% cap rate for $20.0M with a 60% loan of $12.0M and $8.0M of equity. Sold on the same NOI at a 6.0% cap rate, it fetches about $16.7M. After repaying the loan, about $4.7M is left: a loss of about $3.3M, roughly 42% of the equity, from a one-point move. To hold the $20.0M value at 6.0%, NOI would have to rise 20%, to $1,200,000. This hypothetical ignores principal paid down during the hold, cash flow and transaction costs; our guide to commercial real estate underwriting covers the full sequence.
How REALIST does it
REALIST: stress the cap rate before you sign
REALIST's cap-rate sweep plots implied value across a range of exit caps. Financing stress walks LTV, rate and amortization through downside scenarios, and vacancy stress shows the break-even occupancy on any use mix. You leave knowing which assumption matters most, not just what the base case looks like.
Open a property file and the underwriting model is already loaded, with per-floor rent assumptions, conservative operating expenses and a neighborhood benchmark cap rate. Every assumption is a visible, editable input, and moving a slider updates the return picture in the same frame. A verdict score shows where the asset lands, supported, stretched or aggressive, given the inputs on screen; the decision stays with you.
REALIST API returns the same first-pass numbers on demand, including NOI and the implied cap rate against the ask, for any property.
Questions
What is a cap rate?
A cap rate, or capitalization rate, is a property's net operating income divided by its value or price. It is the property's one-year yield before financing.
How do you calculate a cap rate?
Divide the annual net operating income by the price. A property with NOI of $500,000 priced at $8,000,000 has a cap rate of 6.25%; turned around, value equals NOI divided by the cap rate.
What is a good cap rate?
It depends on the asset, its market and the buyer. A higher cap rate pays more income for the price but usually carries more risk or less growth, so the best test is what comparable buildings in the same submarket have actually sold for.
What is an exit cap rate?
The exit or terminal cap rate is the rate assumed when the property is sold at the end of the hold, used to estimate the sale price. Underwriters usually set it above the going-in rate to allow for an older building and uncertain markets.
Why do cap rates rise when interest rates rise?
Higher rates raise the cost of borrowing and the return investors can earn on safer assets, so buyers pay less for the same income. Cap rates usually follow with a lag and not one for one, because rent growth can offset part of the change.
