## What is Cap Rate?

**Cap Rate**—short for Capitalization Rate—is a measure of the expected rate of return on a real estate investment, such as a commercial rental property.

In simple terms, the cap rate converts one period of economic benefit, or net operating income (NOI), into an estimate of value.

Therefore, the cap rate is conceptually a function of the income potential of a rental property and the perceived risk attributable to the investment.

- The cap rate in real estate is a shorthand abbreviation for the term, “Capitalization Rate”.
- The cap rate is the expected return on a rental property based on its income potential and implied risk.
- The cap rate formula divides the net operating income (NOI) of a property by its current market value.
- The higher the cap rate, the higher the potential return and risk, all else being equal.
- There is no “good” cap rate per se since the target return is a subjective matter, but most commercial real estate (CRE) investors perceive cap rates around the 5% to 10% range as ideal.
- The shortcoming of the cap rate is the implicit assumption that the economic benefit retrieved in one period will continue in perpetuity.

Table of Contents

- How Does the Cap Rate Work?
- How to Calculate Cap Rate
- Cap Rate Formula
- Cap Rate Example
- How to Calculate NOI Using Cap Rate
- Implied Cap Rate vs. Actual Cap Rate: What is the Difference?
- What is a Good Cap Rate?
- Is a Higher Cap Rate Better?
- Cap Rate vs. Cash on Cash Return: What is the Difference?
- Cap Rate Expansion vs. Compression: What is the Difference?
- Cap Rate Calculator
- 1. Commercial Rental Property Investment Assumptions
- 2. Stabilized NOI Calculation
- 3. Real Estate Pro Forma Forecast
- 4. Cap Rate Calculation Example
- 5. Income Approach Appraisal (NOI / Cap Rate)
- 6. Cap Rate Sensitivity Analysis Matrix

## How Does the Cap Rate Work?

The cap rate is a fundamental measure of risk and return in the commercial real estate (CRE) market.

Commercial real estate investors use the cap rate to establish the relative attractiveness of a particular property to determine whether the asking price is overpriced, underpriced, or priced fairly.

Therefore, the cap rate answers the fundamental question of, *“For each dollar spent to acquire the property, what is the annual net operating income (NOI) expected to be generated?”*

The cap rate formula compares the net operating income (NOI) of a real estate property investment to its fair value to quantify the anticipated rate of return.

**In practice, the cap rate serves as the primary shorthand whereby properties of comparable risk and return can be analyzed side-by-side.**

By converting the stabilized NOI of a property into a percentage, the implied cap rate is a standardized metric that facilitates fair comparisons between different properties (“apples-to-apples”).

Conceptually, a higher capitalization rate implies a higher potential return on investment (ROI) and more risk, whereas a lower cap rate coincides with a lower potential return but less risk.

The property value of a real estate asset can be derived from the capitalization rate since the metric reflects the expected yield on a property investment.

Given the implied property valuation, a real estate investor can estimate the purchase price to offer to acquire a property where the minimum required rate of return (or “hurdle rate”) is attainable.

## How to Calculate Cap Rate

The cap rate is calculated by dividing a rental property’s net operating income (NOI) by its market value as of the present date.

**Net Operating Income (NOI)**➝ The NOI measures a property’s earnings potential based on its core income drivers, namely rent payments, minus its direct operating expenses (e.g., property taxes).**Property Value**➝ The current market value, on the other hand, is the fair value of a property on the present date, albeit the purchase price can be used at times.

The step-by-step process to calculate the cap rate for a rental property investment is as follows:

**Step 1 ➝**Calculate Net Operating Income (NOI)**Step 2 ➝**Estimate the Property Value (or Purchase Price)**Step 3 ➝**Divide NOI by the Property Value**Step 4 ➝**Convert into Percentage Form

## Cap Rate Formula

The formula for calculating the cap rate divides net operating income (NOI) by the market value of a property, as of the present date.

**Cap Rate (%) =** Net Operating Income (NOI) **÷** Property Value

Where:

**Net Operating Income (NOI) =**(Rental Income

**+**Ancillary Income)

**–**Direct Operating Expenses

The NOI component must reflect the pro-forma income the rental property expects to generate at stabilization (i.e. “steady-state”).

The term “stabilization” refers to the time at which the underlying property of a development project or strategic acquisition is considered complete.

The cap rate formula does not include mortgage payments or interest because on the logic that mortgage costs and interest expense are classified as financing costs (and thus, not part of a property’s core operations).

## Cap Rate Example

Suppose a commercial rental property is expected to generate $12 million in net operating income (NOI) in 2024, and comparable properties nearby are trading at a 6.0% market cap rate.

- Net Operating Income (NOI) = $12 million
- Market Cap Rate (%) = 6.0%

The 6% market cap rate reflects the annual percentage return on investment (ROI) on the rental property, assuming the property was purchased outright without financing.

The direct capitalization method, one of the core real estate appraisal techniques, states the value of a property can be estimated by dividing its stabilized NOI by the market cap rate.

**Implied Property Value =**Stabilized NOI

**÷**Market Cap Rate

Given the 6.0% market cap rate, the implied market value of the property is $200 million.

- Implied Property Value = $12 million ÷ 6.0% = $200 million

Since net operating income (NOI) and property value—the two variables in the cap rate formula—are known, we can solve for the cap rate by dividing the NOI by the property value.

- Cap Rate = $12 million ÷ $200 million = 6.0%

## How to Calculate NOI Using Cap Rate

The relationship between net operating income (NOI) and the capitalization rate are closely intertwined.

By rearranging the cap rate equation, we can derive the net operating income (NOI) of a property.

The formula to derive the cap rate from NOI involves multiplying the implied property value by the cap rate.

**Net Operating Income (NOI) =**Implied Property Value

**×**Cap Rate

The cap rate is thereby the inverse of a multiple, such as EV/EBITDA.

The commonality between the two ratios is that each metric is composed of unlevered metrics—i.e. property value, net operating income (NOI), enterprise value (TEV) and EBITDA—because the two measure core operating performance.

Hence, the cap rate and EV/EBITDA are the industry-standard metrics to perform comparative analysis (or “comps”) in their respective fields.

## Implied Cap Rate vs. Actual Cap Rate: What is the Difference?

One of the drawbacks of the cap rate is how the actual rental income can deviate from the projected income.

There are countless unforeseeable factors—both internal and external—such as unanticipated tenant vacancies and unfavorable market conditions (i.e. rising interest rates, economic recession).

On that note, the scope of the implied cap rate is limited since the return reflects a pro-forma estimate of the property’s income post-stabilization as of the date of analysis (Year 1).

**Implied Cap Rate =** Stabilized NOI **÷** Purchase Price

The property value component can either be the fair value of the real estate asset estimated via an independent property appraisal, or the asking price set by the seller.

From the perspective of the seller, the actual cap rate is the historical NOI on a trailing twelve month (TTM) basis divided by the realized sale price.

**Actual Cap Rate =** NOI at Exit **÷** Sale Price

The variance between the fair value and asking price on a given property reflects the subjective attribute of the cap rate, akin to the discount rate for corporate valuation.

The wider the “spread“ between the offer value and asking price, the greater the upside in potential return (or downside risk) for both the buyer and seller.

Hence, the necessity for both parties to negotiate an amicable purchase agreement (and sale price), where the “middle ground” is reached.