What Is a Cap Rate in Commercial Real Estate?

The capitalization rate, commonly called the cap rate, is one of the most widely used measurements for evaluating income-producing commercial real estate. It compares a property’s annual net operating income with its value or purchase price.

Investors use cap rates to make preliminary comparisons between commercial properties and to understand the relationship between a property’s operating income and its price. Cap rates are commonly discussed when evaluating office buildings, retail properties, multifamily investments, industrial properties, warehouses and other income-producing real estate.

How to Calculate a Commercial Property’s Cap Rate

To calculate cap rate, first determine the property’s annual net operating income. Then divide the NOI by the property’s purchase price or current value.

In this example, the property’s annual net operating income represents 8% of its $1.5 million purchase price before considering financing costs, income taxes and certain other investor-specific expenses.

What Is Net Operating Income (NOI)?

Net operating income is generally calculated by taking the property’s operating revenue and subtracting its operating expenses. Revenue may include base rent, reimbursements and other property-related income.

Operating expenses can include items such as property taxes, insurance, maintenance, management expenses, utilities paid by the owner and other ordinary costs of operating the property.

Mortgage principal and interest are generally not deducted when calculating NOI for cap-rate purposes. This allows investors to evaluate the property’s operating performance separately from the financing structure used by a particular buyer.

How to Estimate Property Value Using a Cap Rate

Cap rates can also be used in reverse. If you know a property’s annual NOI and have selected an appropriate market cap rate, you can estimate an indicated property value.

This is only an analytical estimate. Actual commercial property value can also be influenced by comparable sales, lease terms, tenant quality, remaining lease duration, location, property condition, financing conditions, market demand and other factors.

What Is a Good Cap Rate?

There is no single cap rate that is considered good for every commercial property. Appropriate cap rates vary by property type, location, tenant profile, lease structure, property condition, market conditions and perceived investment risk.

A lower cap rate may sometimes be associated with properties that investors perceive as having lower risk or stronger long-term income characteristics. A higher cap rate may indicate the potential for greater income relative to the purchase price, but it can also reflect additional risk or uncertainty.

For this reason, cap rate should not be evaluated in isolation. Investors should compare a property with relevant market transactions and review the underlying income and expenses.

Cap Rate vs. Cash-on-Cash Return

Cap rate and cash-on-cash return measure different things. Cap rate focuses primarily on the property’s operating income relative to its value without considering the investor’s mortgage financing.

Cash-on-cash return measures annual pre-tax cash flow relative to the actual cash invested. Because financing affects cash flow and the amount of cash required to acquire a property, cash-on-cash return can differ substantially from the property’s cap rate.

For a more complete commercial investment analysis, investors may also examine debt service, debt service coverage ratio (DSCR), cash flow, cash-on-cash return, vacancy assumptions, capital expenditures and potential future rent growth.

Factors That Can Affect Commercial Property Cap Rates

Commercial real estate cap rates can be affected by many factors, including property location, asset class, tenant creditworthiness, remaining lease terms, occupancy, building condition, market rents, interest rates, supply and demand, expected rent growth and overall investment risk.

Two properties with similar income can therefore trade at very different prices and cap rates. Understanding why those differences exist is an important part of commercial real estate analysis.

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