How this works
Capitalization rate is the unlevered annual return on a real-estate investment, expressed as a percentage of property value. It strips out financing — no mortgage, no leverage — to let you compare the underlying yield of two buildings on equal terms. Cap rate = NOI / Property Value, where NOI (net operating income) is annual rental income minus annual operating expenses (taxes, insurance, maintenance, property management, vacancy allowance), but BEFORE mortgage interest, depreciation, and income taxes.
Why it matters. Two buildings priced identically might have wildly different cap rates if one has higher rents or lower expenses. A "5 cap" building yielding $50K NOI is priced at $1M; a "8 cap" building with the same NOI is priced at $625K. The market sets cap rates, so a building trading at an above-market cap rate either has hidden risk (deferred maintenance, neighbourhood decline, lease-up risk) or is genuinely under-priced. Use cap rate to spot the difference.
Typical bands. Prime urban multifamily: 4–5%. Secondary urban: 5–6.5%. Suburban / smaller markets: 6–8%. Tertiary / industrial: 7–9%. Anything above 10% needs scrutiny — the seller is pricing in either tenant churn, structural problems, or location risk that the buyer should validate. Cap rates compress (decline) in low-interest-rate environments because investors will accept lower yields when bonds and savings pay less; they expand when rates rise. The cap rate is the single most-watched metric in commercial real estate.
The formula
Always use a stabilised NOI — actual rents collected, not market or pro-forma. Subtract a 5–10% vacancy allowance even on fully-occupied buildings. Don't include capex (roof replacement, HVAC) in NOI; it shows up separately when calculating cash-on-cash return.
Example calculation
- Building generates $80,000 gross annual rent, $25,000 in operating expenses, priced at $750,000.
- NOI = 80,000 − 25,000 = $55,000. Cap Rate = 55,000 / 750,000 = 7.33%.
Frequently asked questions
What's the difference between cap rate and cash-on-cash return?
Cap rate ignores the loan; cash-on-cash counts it. Cap = NOI / Property Value. Cash-on-cash = (NOI − annual debt service) / Cash Invested (down payment + closing costs + initial reserves). On a leveraged purchase you typically have a higher cash-on-cash than cap rate, because the loan amplifies the equity return — but also amplifies losses. Use cap rate for property comparisons, cash-on-cash for your specific deal economics.
Should I include my time managing the property?
Yes — at the cost of a third-party property manager (typically 6–10% of gross rent for residential, 4–6% for commercial). If you self-manage, you're trading time for cash. Excluding the management fee inflates NOI and your cap rate, making the deal look better than it is. The "true" cap rate for buyer comparison should always include a market-rate management fee, even if you'll personally do it.
How do interest rates affect cap rates?
Inversely, mostly. When the 10-year Treasury yields 1%, a 4% cap rate looks attractive — a 3-percentage-point spread over risk-free. When the 10-year yields 4.5%, a 4% cap is no longer a sensible risk premium and prices fall (cap rates rise) until the spread widens. The 2022–2024 rate hikes triggered roughly 100–150 basis-point cap-rate expansion across most US property types — i.e. price drops of 15–25% holding NOI constant. This is also why cap rate is a forward-looking metric: today's cap rate is sensitive to where rates go next.