Cap rate (capitalization rate) is the ratio of a property’s net operating income to its market value or purchase price, expressed as a percentage: cap rate equals NOI divided by value. It is the primary shorthand for commercial real estate valuation. A lower cap rate implies a higher value relative to income; a higher cap rate implies a lower one.
How is cap rate calculated?
Cap rate = Net operating income / Property value
The same equation solves for value: value equals NOI divided by cap rate. A property generating $1 million in net operating income and valued at $20 million has a 5.0% cap rate.
Illustrative example:
| Input | Amount |
|---|---|
| Net operating income | $1,000,000 |
| Property value | $20,000,000 |
| Cap rate | $1,000,000 / $20,000,000 = 5.0% |
Because value is NOI divided by cap rate, a small move in the cap rate produces a large move in value. A 50-basis-point cap rate expansion on the same property means it is now worth roughly $18.2 million at 5.5%, a $1.8 million decline in value with no change in income.
| Cap rate | Implied value at $1,000,000 NOI | Change in value |
|---|---|---|
| 5.0% | $20,000,000 | Baseline |
| 5.5% | $18,181,818 (roughly $18.2 million) | Roughly $1.8 million decline |
What does a cap rate tell you?
A lower cap rate implies higher value relative to income, often reflecting lower perceived risk or stronger growth expectations. A higher cap rate implies lower relative value. Cap rates vary significantly by property type, market and asset quality: a Class A multifamily property in a gateway market might trade at a 4.5% cap rate, while a suburban office building might trade at 8.0% or higher.
Cap rate is a pricing measure, which separates it from its lender-side sibling. Debt yield divides the same NOI by the loan amount instead of the property value, so it measures the lender’s exposure rather than the property’s price.
Why do lenders care about cap rates?
Cap rates directly affect loan-to-value ratios and refinancing feasibility. When cap rates rise, values fall, and a borrower’s LTV increases even if NOI has not changed. That can trigger covenant violations or make refinancing impossible at the same leverage level. The $1.8 million decline in the example above happens with no change in the property’s income or its debt service coverage ratio.
This is why lenders stress-test underwriting at higher cap rates and why borrowers need to understand their exit cap rate assumptions. The relationship between interest rates and cap rates is not one-to-one, but rising rate environments generally put upward pressure on cap rates, which creates refinancing risk for leveraged borrowers.
Frequently Asked Questions
What is a good cap rate?
There is no single good cap rate; it depends on property type, market and asset quality. A Class A multifamily property in a gateway market might trade at 4.5%, while a suburban office building might trade at 8.0% or higher. What matters is how a property’s cap rate compares with similar assets.
Does a higher cap rate mean a better deal?
A higher cap rate means more income per dollar of value, which usually reflects higher perceived risk or weaker growth expectations rather than a bargain. A lower cap rate reflects lower perceived risk or stronger growth expectations.
How does a cap rate affect loan-to-value?
LTV is the loan balance divided by value, and value is NOI divided by cap rate. When the cap rate rises, value falls and LTV rises even though the loan balance and NOI are unchanged.
What is the difference between cap rate and debt yield?
Both start with NOI. Cap rate divides it by the property’s value; debt yield divides it by the loan amount. Cap rate measures the property’s pricing, debt yield measures the lender’s exposure.
Do cap rates move with interest rates?
Not one-to-one, but rising rate environments generally put upward pressure on cap rates. That pressure lowers values and creates refinancing risk for leveraged borrowers.
Related Terms
- Net Operating Income
- Loan-to-Value
- Debt Yield
- Debt Service Coverage Ratio
- Loan-Level Valuations for Investment Committee: Debt in the Hold/Sell Decision
- DSCR vs. Debt Yield: Which Metric Actually Matters for Your Portfolio?
- How Interest Rates Affect Cap Rates: Spreads and Lags
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.
Sources
- LoanBoss CRE Debt Glossary