The capitalization rate, or cap rate, is one of the most important metrics in commercial real estate. It is calculated by dividing a property’s Net Operating Income (NOI) by its value. Commercial real estate professionals use cap rates to compare property returns, assess market trends, and estimate valuation. This guide will break down the cap rate formula, provide real-world examples, and address common misconceptions.
Table of Contents
- What is a Cap Rate? Definition & Calculation
- How to Calculate Cap Rate
- Using Cap Rate for Valuation
- Cap Rate Valuation Example
- Intuition Behind the Cap Rate
- What is a Good Cap Rate?
- Current Cap Rates in 2025: Market Trends by Property Type
- When, and When Not, to Use a Cap Rate
- Components of the Cap Rate
- Advanced Cap Rate Calculation Methods
What is a Cap Rate? Definition & Calculation
The cap rate (capitalization rate), is a simple formula used in real estate investment analysis and valuation. It is calculated as the ratio of Net Operating Income (NOI) to property value:
For example, if a property recently sold for 1,000,000 and had a stabilized NOI of 100,000, then the cap rate would be 100,000/1,000,000, or 10%.
In practice, the cap rate is almost always expressed in terms of an annual NOI.
How to Calculate Cap Rate
There are three simple steps to calculate the cap rate:
- Determine the property’s annual Net Operating Income (NOI).
- Find the current market value or purchase price of the property.
- Divide NOI by the property value to get the cap rate percentage.
Use our Cap Rate Calculator to quickly estimate a property’s cap rate. For a more detailed analysis, our Proforma App goes beyond quick calculations, allowing you to build customized proformas, model different scenarios, and generate professional reports with ease.
Using Cap Rate for Valuation
The cap rate is widely used for real estate valuation through direct capitalization. The formula can be rearranged to solve for property value:
For example, if an investor is analyzing a property with an annual NOI of $980,000 and a market cap rate of 5.7%, the estimated property value would be:
$980,000 / 5.7% = $17,192,982 (rounded to $17,190,000 in practice).
This method provides a quick estimate of property value but assumes a stabilized NOI. If the property’s income is variable, then a discounted cash flow (DCF) analysis is the preferred and often only reliable valuation method.
The cap rate valuation formula is a variation of the perpetuity formula in finance, where the present value of a constant cash flow is determined by dividing it by a discount rate (required rate of return). While real estate cash flows are not truly perpetual, direct capitalization remains a widely used and intuitive valuation method in the industry.
Cap Rate Valuation Example
Let’s take a closer look at how this works. One way an appraiser can estimate the market value of a property is by using the direct capitalization valuation method.
For example, suppose an appraiser is tasked with estimating the market value of a Class A office building that is expected to produce 980,000 in net operating income next year. The appraiser also has data on the following recently sold comparable properties:
Based on the NOI and recent sale prices for each comparable property, we can estimate an average market-based capitalization rate of 5.7%. Using the subject property’s annual NOI of 980,000 and the derived capitalization rate of 5.7%, the appraiser could estimate the property’s market value as:
In practice, this value would usually be rounded down to $17,190,000. While this simplified example doesn’t involve the level of detail and rigor of a formal appraisal, it demonstrates the same fundamental direct capitalization technique used by professional appraisers.
Intuition Behind the Cap Rate
What is the cap rate actually telling you? One way to understand the cap rate intuitively is to view it as the percentage return an investor would receive on an all-cash purchase. For example, if a property has a cap rate of 5.7%, an all-cash investment would yield an annual return of 5.7%, not accounting for non-operating costs.
Another way to think about the capitalization rate is to compare it to the earnings yield in stocks, which is calculated as earnings per share (EPS) divided by stock price. Similarly, the cap rate is determined by NOI divided by property value. The inverse of the earnings yield is the Price-to-Earnings (P/E) ratio, while the inverse of the cap rate results in an NOI multiple.
Comparing Cap Rate to Stock Market Metrics
| Metric | Formula | Interpretation |
|---|---|---|
| Cap Rate | NOI / Property Value | Annual return on an all-cash investment (before non-operating costs) |
| Earnings Yield | EPS / Stock Price | Annual return on a stock investment, analogous to the cap rate for real estate |
| P/E Ratio | 1 / Earnings Yield | The number of years it takes to recover the investment at current earnings |
| NOI Multiple | 1 / Cap Rate | The number of years it takes to recover the investment at the current NOI |
This inverse relationship between cap rates and NOI multiples is key to understanding how investors value income-producing properties. A lower cap rate means a higher valuation relative to income, while a higher cap rate suggests a lower valuation.
Understanding the NOI Multiple
A property’s NOI multiple, calculated as the inverse of its cap rate, directly indicates how long it takes to recover your initial investment at current NOI:
NOI Multiple = 1 / Cap Rate
For example:
- 5% cap rate: NOI Multiple = 1 ÷ 0.05 = 20 years
- 10% cap rate: NOI Multiple = 1 ÷ 0.10 = 10 years
Lower cap rates indicate higher property valuations, as investors are willing to pay more for stable, lower-risk income streams.
To visualize this relationship, consider the following chart:
As shown in the chart, capitalization rates and NOI multiples are inversely related. That is to say, as the cap rate increases, the NOI multiple decreases. Investors can use this relationship to quickly assess whether a property is priced attractively compared to its expected returns.
What is a Good Cap Rate?
A “good” cap rate depends on your investment goals, risk tolerance, and market conditions. Sellers typically prefer lower cap rates because they mean higher sale prices, while buyers favor higher cap rates since they imply lower prices relative to income. But even with buyers there is a range depending on investment strategy:
- Conservative Investors: Usually favor lower cap rates in stable markets for predictable returns.
- Opportunistic or Value-Add Investors: Often pursue higher cap rates, betting improvements or market shifts will increase returns.
The best way to judge a cap rate is by comparing it to similar properties in the same market. For instance, if Class A office buildings in your submarket typically trade at a 7% cap rate and you find one at 9%, ask yourself why. Is there something wrong with the building (e.g., deferred maintenance, short-term leases, struggling tenants), or is it simply a motivated seller?
In general, prime locations with stable demand usually command lower cap rates because they’re considered safer. Older or more specialized properties (e.g., older hotels, fringe retail) often have higher cap rates to reflect greater uncertainty.
The key point is that there’s no universal “good” cap rate. It’s all about context—property type, location, and strategy. A 6% cap rate might be great for a trophy office building in a big city, but the same number could be too low for a distressed property in a weaker market.
Current Cap Rates in 2025: Market Trends by Property Type
Commercial real estate cap rates have risen due to higher interest rates and investor caution. The average U.S. cap rate increased from 6.4% in 2023 to 7.2% by late 2024.
Below are current cap rate ranges by property type, along with key market trends. This data is sourced from industry reports, including CBRE, NAR, CoStar, and IRR, reflecting mid-2024 market conditions.
| Nationwide Cap Rates by Property Type | |||
|---|---|---|---|
| Property Type | Cap Rate Range | Average Cap Rate | Key Trends |
| Multifamily (Apartments) | 5.0% – 6.5% | ~6.0% | Cap rates have risen ~60 bps YoY due to interest rates. Demand is strong, but high supply is pushing vacancy rates up. |
| Industrial (Warehouses) | 5.5% – 7.5% | ~6.7% | Cap rates increased ~150 bps from 2022. Strong e-commerce demand keeps prime logistics facilities in high demand. |
| Office | 6.5% – 10%+ | ~8.8% | Office distress continues. Trophy assets trade at 6-7%, but many Class B/C offices exceed 9%+. Vacancy at record highs. |
| Retail | 6.0% – 7.5% | ~6.9% | Retail is stable with ~4% vacancy. Grocery-anchored centers trade lower, while malls see higher cap rates due to risk. |
| Hospitality (Hotels) | 7.0% – 10%+ | ~9.0% | Hotels recovered, with RevPAR above 2019 levels. Business travel still lags, and higher financing costs keep cap rates high. |
We can also zero in on top markets to see how cap rates change for the same property type based on location:
| City | Multifamily | Industrial | Office | Retail | Hospitality |
|---|---|---|---|---|---|
| New York | ~6.2% | 5.0%–5.5% | 6%–8%+ (Class B/C higher) | 5.5%–6.3% | ~6%–8% |
| Los Angeles | ~5.3% | 5.0%–5.5% | ~6.9% (older up to 8%+) | ~5.4% (prime lower) | ~4%–8% |
| Chicago | ~6.8% | 5.5%–6.0% | 8%–9%+ (distressed 10%+) | 6.5%–7.5% | 6%–8% |
| Houston | ~5.6% | ~5.3% | 9%–10%+ (some 12%+) | ~7.2% | 7%–9% |
| San Francisco | ~5.5% | 5.0%–5.5% | 7%–8%+ (distressed higher) | ~5.0% (prime lower) | 5%–8% |
Understanding current cap rate trends is important, but knowing when and how to use cap rates equally important. While cap rates provide a quick way to assess investment potential, they have limitations depending on the property’s income characteristics and market conditions. Let’s explore when cap rates are useful—and when a more detailed analysis is required.
When (and When Not) to Use a Cap Rate
The cap rate is widely used in commercial real estate for quick, initial property valuation and investment comparisons. It’s particularly effective for:
- Comparing Investment Options: Quickly sizing up similar properties. For example, if two similar properties have cap rates of 5% and 10%, the property with the higher cap rate indicates greater risk—but potentially higher returns.
- Analyzing Market Trends: Observing historical cap rate trends can signal market direction. Falling cap rates (“cap rate compression”) suggest rising property values and a competitive market environment.
However, cap rates aren’t suitable for every situation. Specifically, avoid relying solely on cap rates if the property’s NOI is irregular or significantly fluctuates over time. In these cases, a detailed Discounted Cash Flow (DCF) analysis, which accounts for variations in cash flow and the time value of money, provides a more accurate valuation. In these more complex situations, investors commonly use the Internal Rate of Return (IRR), Extended Internal Rate of Return (XIRR), and Net Present Value—key outputs of DCF analysis—to measure investment performance.
Components of the Cap Rate
What are the components of the cap rate, and how can they be determined? One way to think about the capitalization rate is that it’s a function of the risk-free rate of return plus some risk premium.
In finance, the risk-free rate is the theoretical rate of return of an investment with no risk of financial loss. Of course, all investments carry some risk in practice. However, since U.S. Treasury bonds are considered to be very safe, the interest rate on a U.S. Treasury bond is normally used as the risk-free rate.
How can we use this concept to determine cap rates?
Suppose you have $10,000,000 to invest, and 10-year treasury bonds are yielding 3% annually. This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks.
What if you were presented with an opportunity to sell your treasuries and instead invest in a Class A office building with multiple tenants? A quick way to evaluate this potential investment property relative to your safe treasury investment is to compare the cap rate to the yield on the treasury bonds.
Suppose the acquisition cap rate on the investment property was 5%. This means that the risk premium over the risk-free rate is 2%. This 2% risk premium reflects all the additional risk you assume over and above the risk-free treasuries, which considers factors such as:
- Age of the property.
- Creditworthiness of the tenants.
- Diversity of the tenants.
- Length of tenant leases in place.
- Broader supply and demand fundamentals in the market for this particular asset class.
- Underlying economic fundamentals of the region including population growth, employment growth, and inventory of comparable space on the market.
- Wider societal trends like remote work, AI, etc.
When you break down these components of the cap rate, it reveals their relationship with the risk-free rate and the overall capitalization rate. However, the specific percentages assigned to each risk factor, are ultimately subjective and rely on individual business judgment and experience.
Is cashing in your treasuries and investing in an office building at a 5% acquisition cap rate a good decision?
This, of course, depends on how risk-averse you are. An extra 2% yield on your investment may or may not be worth the additional risk inherent in the property. Perhaps you can secure favorable financing terms and using this leverage you could increase your return from 5% to 8%. If you are a more aggressive investor, this might be appealing to you. On the other hand, you might want the safety and security that treasuries provide, and a 3% yield is adequate compensation in exchange for this downside protection.
Advanced Cap Rate Calculation Methods
There are some advanced cap rate calculation methods used by appraisers and investors that you should be aware of, most notably the band of investment method and the gordon model.
Band of Investment Method
The band of investment method considers returns for both lenders and equity investors. It applies the Weighted Average Cost of Captial (WACC) formula:
The Weighted Average Cost of Capital (WACC) formula is derived from the fact that property cash flow is equal to the sum of cash flow to debt and equity holders. That means if we know two out of the three variables, then the WACC formula can be used to solve for the unknown third component. In other words, when we know the required returns for lenders and investors, then we can calculate the cap rate.
For example, suppose we survey lenders and learn we can secure a loan for a particular property at an 80% Loan to Value (LTV), amortized over 20 years at 6%. This results in a mortgage constant of 0.0859. Further, suppose that a survey of investors reveals the required return on equity is 15%. This results in a weighted average cap rate calculation of 9.87%:
- Loan-to-Value (LTV): 80%
- Loan Constant: 8.59%
- Required Equity Return: 15%
This band of investment calculation is often used by appraisers when comparable sales data is difficult to find. In cases where comparable sales data is sparse or non-existent, surveys of investors and lenders can provide reliable data to estimate the cap rate using the band of investment methodology.
The Gordon Model
One other approach to calculating the cap rate worth mentioning occurs when NOI isn’t constant but is instead expected to grow at a constant rate. This is the same technique used to value a growing perpetuity. It is also used to value stocks with dividend growth using the dividend discount model, sometimes called the Gordon Model.
If you expect NOI to grow each year at some constant rate, then you can turn this constantly growing stream of cash flows into a simple cap rate approximation.
This formula solves for value, given cash flow, the discount rate, and a constant growth rate. From the definition of the cap rate, we know that value also equals NOI divided by the cap rate.
This means that the capitalization rate can be broken down into two components, the discount rate, and the growth rate. That is, the cap rate is simply the discount rate minus the growth rate.
How can we use this? Suppose we are looking at a building with a stabilized NOI of $100,000 and in our analysis, we expect that the NOI will increase by 1% annually. How can we determine the appropriate cap rate to use? Using the Gordon Model, we can simply take our discount rate and subtract out the annual growth rate. If our discount rate (usually the investor’s required rate of return) is 10%, then the appropriate cap rate to use in this example would be 9%, resulting in a valuation of $1,111,111.
The Gordon Model is a useful concept to know when evaluating properties with growing cash flows. However, it’s not a one-size fit all solution and has several built-in limitations. For example, what if the growth rate equals the discount rate? This would yield an infinite value, which of course is nonsensical. Alternatively, when the growth rate exceeds the discount rate, then the Gordon Model yields a negative valuation, which is also nonsensical.
These built-in limitations don’t render this technique useless, but you do need to be aware of them. Always make sure you understand the assumptions you are making in an analysis and whether they are reasonable or not.
Cap Rate Cheat Sheet
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The Many Layers of Valuation
Commercial real estate valuation is a multi-layered process and usually begins with simpler tools than the discounted cash flow analysis. The cap rate is one of these simpler tools that should be in your toolkit. The capitalization rate is widely used and can communicate a lot about a property quickly, but it can also exclude many important factors in a valuation, most notably the impact of irregular cash flows.
The solution is to create a multi-period cash flow projection and discounted cash flow analysis to arrive at a more accurate valuation. If you need help building a cash flow projection and running a discounted cash flow analysis, consider giving our commercial real estate analysis software a try.
Conclusion
In this article, we defined the cap rate, walked through an example of how an appraiser uses the capitalization rate to estimate the market value of a property, and then we looked at the intuition behind the calculations. Next we covered what a good cap rate is, when not to use a cap rate, and discussed how to think about the components of the cap rate. Finally, we discussed the band of investment method and Gordon model as practical ways to calculate the capitalization rate when you have limited information or growing cash flows.