Ask any commercial real estate broker about a listing and you will hear a cap rate within the first thirty seconds. It is the industry’s single most-cited valuation metric, and for good reason: it is a fast, simple way to compare income-producing properties. But like any single number, it can mislead when treated as more than it is.
The basic formula
Cap rate equals Net Operating Income (NOI) divided by Property Value.
An office building with $500,000 in NOI selling for $7 million is trading at roughly a 7.1% cap rate. Higher cap rates generally imply higher risk or slower growth expectations; lower cap rates imply the opposite.
What cap rate captures well
- Relative pricing between comparable properties in the same submarket.
- Direction of market sentiment through cap rate expansion or compression over time.
- A quick check on whether a listing is priced within reason.
What it misses
- Growth. A stabilized property with flat rents deserves a higher cap rate than one with contractual bumps or below-market rents.
- Leverage. Cap rate is unlevered. Your actual cash-on-cash return depends heavily on financing terms.
- Quality of income. A 6% cap on a credit tenant with ten years of term is very different from a 6% cap on a month-to-month rent roll.
- Capital needs. Deferred maintenance and near-term capex do not show up in NOI but affect real returns.
Use it as a starting point
The cap rate is the beginning of underwriting, not the end. A thoughtful buyer looks at rent roll rollover, market rent versus in-place rent, capital plan, and tenant credit, and then triangulates value using discounted cash flow and comparable sales alongside the cap rate.
