Capitalization rate (cap rate) measures the annual return on a real estate investment property based on income generated.

Formula: Cap Rate = (Net Operating Income ÷ Property Purchase Price) × 100.

Example: property purchased for $500,000 generates $40,000 annual NOI → cap rate = ($40,000 ÷ $500,000) × 100 = 8%.

NOI calculation: Annual Rental Income − Operating Expenses (property taxes, insurance, maintenance, property management fees, utilities, HOA fees) = NOI.

Do NOT deduct: mortgage payments, depreciation, income taxes, capital improvements—these aren't operating expenses.

Cap rate represents the "return on cost" for an all-cash purchase, ignoring financing effects.

A 7% cap rate means you'd receive 7% annual return if paying cash, taking ~14.3 years to recoup investment from income alone (100 ÷ 7 = 14.3).

Higher cap rates indicate higher returns but often higher risk (Class C/D properties, secondary markets).

Lower cap rates indicate "safer" investments in prime locations (Class A properties, major metros) where appreciation potential compensates for lower cash flow.

Good cap rates vary by property type, location, and market conditions. 2025 benchmarks by asset class: Multifamily (apartments)—Class A (new construction, prime locations): 4.5-6.5%, Class B (good condition, decent areas): 5.5-7.5%, Class C (older, working-class areas): 7.5-10%.

Single-family rentals—Primary markets (NYC, LA, SF): 3-5%, Secondary markets (Phoenix, Austin, Nashville): 5-7%, Tertiary markets (smaller cities): 7-10%.

Commercial office—Downtown Class A: 5-7%, Suburban Class B: 7-9%, Secondary markets: 8-12% (office cap rates elevated post-COVID due to remote work).

Retail—Grocery-anchored centers: 6-8%, Strip malls: 7-9%, Single-tenant net lease (Walgreens, Dollar General): 5-7%.

Industrial/warehouse—Class A logistics near ports: 4-6%, Standard warehouse: 6-8%, Cold storage: 5-7% (industrial remains hottest sector).

Geographic variation: High-growth metros (Austin, Nashville, Raleigh)—cap rates 1-2% lower than national average due to appreciation potential compensating for lower immediate yield.

Mature markets (Detroit, Cleveland, Baltimore)—cap rates 2-3% higher, requiring more cash flow to offset lower appreciation.

Risk-return relationship: 4-6% cap rate—"core" strategy, stable cash flow, lower risk, prime properties. 6-8% cap rate—"core-plus," moderate risk, may need light renovations. 8-12% cap rate—"value-add" or "opportunistic," higher risk, often requires significant management/repositioning. >12% cap rate—red flag territory, investigate: severe deferred maintenance, difficult tenant base, declining market, environmental issues, or seller distress.

General rule: cap rate should exceed 10-year Treasury yield by 3-5% as risk premium.

If 10-year Treasury = 4%, target minimum 7-9% cap rate.

Anything below this spread means you're taking real estate risk for bond-like returns.

Cap rate, cash-on-cash return, and Internal Rate of Return (IRR) measure different aspects of real estate performance: Cap Rate—measures property-level return ignoring financing.

Formula: NOI ÷ Purchase Price.

Example: $50,000 NOI, $625,000 price = 8% cap rate.

Same result whether buying all-cash or with mortgage—financing doesn't affect cap rate.

Use: comparing properties on apples-to-apples basis, determining market value (Value = NOI ÷ Market Cap Rate).

Cash-on-Cash Return (CoC)—measures actual cash return on cash invested (down payment + closing costs).

Formula: Annual Pre-Tax Cash Flow ÷ Total Cash Invested.

Example: $50,000 NOI − $30,000 annual mortgage payment = $20,000 cash flow.

Invested $125,000 down payment (20%) + $12,500 closing = $137,500 total cash.

CoC = $20,000 ÷ $137,500 = 14.5%.

Higher than cap rate due to leverage—using debt magnifies returns (and risks).

Use: evaluating actual investor returns accounting for financing structure.

IRR (Internal Rate of Return)—measures total annualized return including cash flow, appreciation, and sale proceeds over entire holding period.

Accounts for: annual cash distributions, mortgage paydown (principal reduction), property appreciation, tax benefits (depreciation), sale proceeds after costs.

Example: $137,500 investment, 5 years of cash flow averaging $20,000/year, sell for $750,000 net after paying off mortgage = $250,000 sale proceeds.

IRR calculation (requires financial calculator): typically 15-25% for successful value-add deals.

Use: evaluating total investment performance, comparing real estate to alternative investments (stocks, bonds).

Comparison example: Property A: 8% cap rate, 14.5% CoC, 18% IRR.

Property B: 6% cap rate, 10% CoC, 22% IRR.

Property A has higher cap rate and CoC (better immediate cash flow).

Property B has higher IRR (better total return including appreciation).

Which is better? Depends on goals: income-focused investors prefer A, total-return investors prefer B.

Most institutional investors target 15-20% IRR as minimum threshold.

Family office investors often accept 12-15% IRR for stable, lower-risk deals.

Value-add/opportunistic funds target 20-30% IRR to compensate for higher risk and illiquidity.

Cap rates have inverse relationship with property values but cannot directly predict appreciation—they reflect current market conditions and risk perceptions.

The mechanics of inverse relationship: if NOI stays constant at $50,000 but market cap rate drops from 8% to 6%, property value increases from $625,000 to $833,333 (33% appreciation).

Formula: Value = NOI ÷ Cap Rate.

Falling cap rates drive appreciation; rising cap rates cause depreciation.

Historical patterns and appreciation drivers: 2010-2019 (post-financial crisis): cap rates compressed from 8-10% to 5-7% in most markets as investors chased yield in low-interest environment → massive appreciation even without NOI growth. 2020-2021 (pandemic): cap rates stayed low or fell further (multifamily, industrial) while office/retail cap rates rose due to sector risk → divergent appreciation by property type. 2022-2024 (rising rates): cap rates expanded 100-200 basis points (1-2%) in many markets as interest rates rose, causing property values to decline 10-30% even as NOI grew. 2025 outlook: if rates stabilize or decline, cap rates may compress again, driving appreciation.

Cap rate compression limits: even in strongest markets, cap rates rarely fall below 3-4% because at that point, real estate yields less than "risk-free" Treasury bonds, making it unattractive.

Warning: buying at historically low cap rates (4-5%) assumes future compression to 3-4% for appreciation—risky bet.

Safer approach: buy at 7-8% cap rates, benefit if rates compress to 6% but still cash flow well if they expand to 9%.

Appreciation forecasting reality check: NOI growth drives sustainable appreciation, not just cap rate compression.

Property with 3% annual NOI growth and stable 7% cap rate appreciates ~3%/year sustainably.

Property bought at 5% cap rate needs either: 3% annual NOI growth to maintain value if cap rate stays 5%, OR cap rate compression to 4% if NOI stays flat (appreciation depends on market sentiment, not fundamentals).

Prudent underwriting: assume cap rates stay constant or expand slightly (add 50-100 basis points for conservative stress testing).

Don't count on cap rate compression—treat it as upside surprise, not base case assumption.

If your investment only works with cap rate compression, you're speculating on market sentiment, not investing based on cash flow fundamentals.

Cap rates enable quick property valuation through direct capitalization method, the most common commercial real estate valuation approach.

Valuation formula: Property Value = Net Operating Income (NOI) ÷ Market Cap Rate.

Step-by-step valuation process: (1) Calculate actual/projected NOI—Gross Rental Income (market rents × total units/square feet) − Vacancy Loss (typically 5-10%) = Effective Gross Income (EGI).

EGI − Operating Expenses (taxes, insurance, maintenance, management, utilities, reserves) = NOI.

Example: 20-unit apartment, $1,200/month average rent.

Gross income: 20 × $1,200 × 12 = $288,000.

Minus 8% vacancy = $265,000 EGI.

Minus $85,000 operating expenses = $180,000 NOI. (2) Determine market cap rate—research recent comparable sales (similar property type, location, quality, size).

If three similar 20-unit buildings sold at 7.2%, 7.5%, and 7.8% cap rates, use 7.5% as market rate.

Alternative: use published market surveys (CBRE, Marcus & Millichap) showing market cap rates by submarket and property class. (3) Calculate value—Value = $180,000 ÷ 0.075 = $2,400,000.

This becomes basis for purchase offer.

Seller asking $2,700,000? Either seller is overpricing, or you're missing income/expense assumptions.

Reconcile by requesting seller's actual financials.

Sensitivity analysis for negotiation: At 7.0% cap rate: $180,000 ÷ 0.07 = $2,571,429 (higher value).

At 8.0% cap rate: $180,000 ÷ 0.08 = $2,250,000 (lower value). 100 basis point (1%) cap rate change = 13% value swing.

Use in negotiation: "Market comps show 7.5% cap rate, but your property has deferred maintenance (new roof needed $80,000).

Adjusting NOI down by $8,000/year for reserves gives $172,000 NOI.

At 8% cap rate (reflecting extra risk) = $2,150,000 value, not $2,700,000 asking price." Limitations and adjustments: Cap rate valuation assumes stabilized NOI (current operations continuing).

Adjust for: below-market rents (increase income to market levels), deferred maintenance (reduce NOI for future capital costs), lease rollover risk (reduce income if major tenant leaving), development potential (separate land value from income value).

Market cap rates reflect current conditions; applying today's 7% rate to project bought at 5% cap rate three years ago doesn't mean value fell—if NOI grew 30%, value still increased despite cap rate expansion.

Always verify NOI claims: request T12 (trailing 12 months) and T3 (trailing 3 months) operating statements, rent rolls, tax bills, insurance policies.

Sellers routinely inflate projected NOI by 10-30% through optimistic occupancy assumptions and understated expenses.

Cap rate variation reflects risk-return tradeoffs across multiple dimensions: (1) Geographic location—Primary markets (NYC, SF, LA, DC): cap rates 4-6%—high property values driven by: limited supply (zoning constraints, geographic barriers), strong job growth (tech, finance, government), wealth concentration, international capital flows.

Secondary markets (Austin, Nashville, Charlotte, Phoenix): cap rates 5.5-7.5%—growing economies but less supply-constrained, more volatile appreciation.

Tertiary markets (smaller MSAs, rural areas): cap rates 8-12%—higher cash flow compensates for limited appreciation potential, economic dependence on single industry, lower liquidity (longer time to sell).

Rural/very small towns: cap rates 10-15%+—reflects high risk: population decline, limited tenant pool, few buyers when selling. (2) Property quality and age—Class A (new construction, institutional quality): lower cap rates, premium pricing for: modern systems (HVAC, electrical), energy efficiency, attractive to credit tenants, lower maintenance capex needs.

Class B (well-maintained, functional): mid-range cap rates, balance of cash flow and appreciation.

Class C (older, deferred maintenance): higher cap rates, "value-add" opportunity but requires capital investment and management intensity.

Class D (significant issues): highest cap rates (12%+), often negative surprise, not true 12% returns—reflects distress. (3) Tenant quality and lease structure—Credit tenants (investment-grade companies): lower cap rates, Walgreens 15-year net lease at 5.5% cap rate reflects low risk, guaranteed income from $50B corporation.

Local small business tenants: higher cap rates (7-9%), risk of tenant default, lease non-renewal.

Multi-tenant retail: highest cap rates (8-12%), vacancy risk when any tenant leaves, re-tenanting costs. (4) Lease term and structure—Long-term net leases (10-25 years, tenant pays all expenses): lowest cap rates (4-6%), bond-like income stream, minimal landlord responsibilities.

Gross leases (landlord pays expenses): moderate cap rates (6-8%), landlord bears expense risk (property tax increases, insurance spikes).

Short-term leases or month-to-month: higher cap rates (8-10%+), reflects income volatility risk. (5) Property type risk profile—Industrial/warehouse: cap rates 5-8%, e-commerce tailwinds, long leases, low tenant turnover.

Multifamily: cap rates 5-8%, recession-resistant (everyone needs housing), steady demand.

Retail: cap rates 7-10%, Amazon disruption risk, traffic pattern changes.

Office: cap rates 7-12% (widening), remote work uncertainty, oversupply in some markets, potential obsolescence. (6) Market supply-demand dynamics—Supply-constrained markets (CA, NY with strict zoning): cap rates 1-2% lower due to scarcity value.

Over-supplied markets (Houston office, Phoenix multifamily 2023-2024 with 30,000+ units delivered): cap rates 1-2% higher as vacancy increases. (7) Interest rate environment—Low rates (2020-2021): cap rates compressed as investors accepted lower yields (5% real estate return beats 1.5% bonds).

High rates (2023-2024): cap rates expanded—7% real estate return less attractive when 10-year Treasuries yield 4.5%.

Cap Rate Spread = Cap Rate − 10-Year Treasury yield.

Historical average: 3-4% spread.

Current (2025): many markets at 2-3% spread, suggesting cap rates may expand further if rates stay elevated, or compress if Fed cuts rates.