Cap rate (capitalization rate) is the ratio of a property’s net operating income (NOI) to its current market value or purchase price, expressed as a percentage. A property generating $1 million in NOI and valued at $20 million has a 5.0% cap rate. Cap rates serve as the primary shorthand for CRE property valuation: a lower cap rate implies higher value relative to income (often reflecting lower perceived risk or stronger growth expectations), while 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 an 8.0% cap rate or higher.
How It Works in Practice
For CRE debt professionals, cap rates are essential because they directly affect loan-to-value ratios and refinancing feasibility. When cap rates rise (values fall), a borrower’s LTV increases even if NOI hasn’t changed — potentially triggering covenant violations or making refinancing impossible at the same leverage level. A 50-basis-point cap rate expansion on a $20 million property at a 5% cap rate means the property is now worth roughly $18.2 million at 5.5%, a $1.8 million decline in value. 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.
Related Terms
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.