Cap Rate in Commercial Real Estate: Formula, Calculation, and Examples

The capitalization rate is the most widely used metric in commercial real estate for quickly estimating property value and comparing investment opportunities. Before bidding on a 200-unit apartment complex or a downtown office tower, investors ask one question first: what’s the cap rate? This guide covers the cap rate formula, how to interpret cap rates by property type, real-world examples with actual numbers, and the limitations every CRE investor should understand.

What Is Cap Rate in Commercial Real Estate?

The capitalization rate (cap rate) is a fundamental metric in commercial real estate that expresses a property’s net operating income as a percentage of its current value. It provides a quick, standardized way to compare the income-producing potential of different properties.

Higher cap rates signal higher current income yield but typically come with greater risk — secondary markets, older properties, or less stable tenants. Lower cap rates signal lower yield but reflect stability, growth potential, and strong demand, such as Class A multifamily in gateway cities like New York or San Francisco.

Cap rate is distinct from return on investment (ROI). ROI accounts for financing, appreciation, tax benefits, and all cash flows over a hold period. Cap rate strips all of that away to isolate income yield at a single point in time, making it ideal for quick property comparisons.

Two important variants to understand: the going-in cap rate is based on a specific deal’s purchase price (what you’re paying today), while the market cap rate is derived from comparable closed transactions in the area (what the market is pricing similar properties at). When evaluating a deal, compare both to determine whether you’re buying above or below market.

The Cap Rate Formula

The cap rate formula relates a property’s income to its value in a single ratio:

Where NOI (Net Operating Income) is calculated as:

• Potential Gross Income (PGI) — total rental income if the property were 100% occupied at market rents
• Minus Vacancy & Collection Loss — expected income lost to vacant units and uncollected rent
• Equals Effective Gross Income (EGI)
• Minus Operating Expenses — property taxes, insurance, maintenance, management fees, utilities
• Equals NOI

NOI explicitly excludes debt service (mortgage payments), capital expenditures, and income taxes. This is what makes cap rate an unlevered metric — it measures property performance independent of how the purchase is financed.

Note that replacement reserves (funds set aside for major future repairs like roofs or HVAC systems) are included by some underwriters and excluded by others. Convention varies by market and lender, so always clarify how NOI is calculated when comparing properties or reviewing broker materials.

The formula also works in reverse — and this is how appraisers and investors most often use it in practice:

How to Interpret Cap Rates by Property Type

Cap rates vary significantly across property types and markets. The table below shows typical cap rate ranges for major CRE asset classes:

These ranges are reflected in the portfolios of major public REITs. Prologis (PLD), the world’s largest industrial REIT, typically acquires logistics properties at cap rates in the 4.5–6.0% range. AvalonBay Communities (AVB) and Equity Residential (EQR), two of the largest multifamily REITs, transact gateway-city apartments at cap rates in the 4.0–5.5% range. Simon Property Group (SPG), the largest retail REIT, acquires premium mall and outlet properties at cap rates that vary widely — from 5% for trophy assets to 7%+ for value-add centers.

What High vs Low Cap Rates Signal

Low cap rates (4–5%) indicate lower perceived risk and often reflect properties in established markets with strong tenant demand, high barriers to entry, and expected rent growth. Gateway-city Class A multifamily properties typically trade at the lowest cap rates because housing demand is consistently strong and vacancy rates are low.

High cap rates (8–10%) indicate higher perceived risk — secondary or tertiary markets, older properties requiring capital investment, less creditworthy tenants, or cyclical property types like hotels. The tradeoff is higher current income yield, which can be attractive for investors prioritizing cash flow over appreciation.

Going-In vs Exit Cap Rate

CRE underwriting distinguishes between two cap rate concepts that every investor must understand:

• Going-in cap rate — NOI at acquisition divided by the purchase price. This is the yield you’re locking in on day one.
• Exit (terminal) cap rate — projected NOI at the time of sale divided by the expected sale price. Used to estimate future disposition value in a hold-period analysis.

Exit cap rates are often assumed to be 50–100 basis points higher than the going-in cap rate to account for property aging, market uncertainty, and the conservative underwriting lenders require. If your going-in cap rate is 5.5% and you assume a 6.0% exit cap, you’re building in a cushion that protects against downside scenarios.

Cap Rate Example

Using Cap Rate to Estimate Value

Now flip the formula. If comparable multifamily properties in the same Dallas submarket have been closing at a 5.75% market cap rate, what is this property worth?

Same Cap Rate, Different Story

Cap rates can be misleading without context. Consider two properties that both trade at a 6.0% cap rate:

Same cap rate, very different risk/return profiles. The retail center offers stable, bond-like income. The office building offers upside potential but requires active management and carries execution risk. Always look behind the number.

Cap Rate vs DCF Valuation

Cap rate and discounted cash flow (DCF) analysis are the two primary valuation approaches in CRE, and they serve different purposes:

Rule of thumb: Use cap rate valuation for stabilized assets with steady, predictable income. Use DCF analysis for transitional properties where income will change materially over the hold period — renovation projects, lease-up scenarios, or repositioning plays.

The two approaches are conceptually connected. Cap rates implicitly embed the return and growth expectations that a DCF model makes explicit. A low cap rate on a gateway multifamily property implies the market expects strong rent growth — a DCF would model that growth year by year rather than baking it into a single ratio.

Learn more about multi-period valuation in our guide to Net Present Value and IRR.

Factors That Affect Cap Rates

Cap rates are not fixed — they shift in response to economic conditions, market dynamics, and property-specific characteristics. Understanding these drivers helps investors anticipate cap rate movements and make better acquisition decisions.

1. Interest Rates — Rising rates push cap rates higher because increased borrowing costs reduce what investors can pay for properties. Falling rates have the opposite effect, compressing cap rates and boosting values. Learn more about how rate changes affect asset prices in our guide to interest rate risk.
2. Location — Gateway and primary markets (New York, Los Angeles, Chicago) command lower cap rates due to deep tenant pools, high barriers to entry, and institutional demand. Secondary and tertiary markets offer higher yields but carry greater risk.
3. Property Type — Multifamily and industrial properties generally trade at lower cap rates due to strong, secular demand drivers. Office and retail face structural headwinds that push cap rates higher.
4. Tenant Quality & Lease Terms — NNN leases with investment-grade tenants (e.g., Walgreens, FedEx, Amazon) compress cap rates because the income stream is highly predictable. Month-to-month leases with small local tenants widen cap rates due to rollover risk.
5. Property Condition & Age — Newer, well-maintained properties trade at lower cap rates. Older assets requiring capital investment trade at higher cap rates to compensate for deferred maintenance risk.
6. Market Supply & Demand — Oversupplied markets with high vacancy push cap rates up. Markets with tight supply and strong absorption compress cap rates as investors compete for limited inventory.
7. Financing Environment — When debt is cheap and readily available, more capital flows into CRE, compressing cap rates. When lending tightens, transaction volume drops and cap rates expand. See our guides on loan amortization and financial leverage for more on how financing shapes returns.

Cap Rate Compression and Expansion

Cap rate compression occurs when cap rates fall, driving property values higher. This happens during periods of strong investor demand, low interest rates, and abundant capital flowing into CRE. Cap rate expansion is the reverse — cap rates rising and property values falling due to economic uncertainty, rising rates, or reduced demand.

For example, industrial cap rates compressed from approximately 7% to 4.5% between 2015 and 2022 as e-commerce growth fueled demand for warehouse and logistics space — a trend reflected in Prologis’s (PLD) portfolio acquisitions during that period. Post-2022, Federal Reserve rate hikes caused moderate expansion back toward 5.5–6.5% as higher borrowing costs cooled investor appetite.

How to Calculate Cap Rate

Calculating cap rate is straightforward once you have reliable income and value figures:

1. Calculate NOI — Start with potential gross income, subtract vacancy and collection losses to get effective gross income, then subtract all operating expenses. Use trailing-12-month actuals or a stabilized pro forma — not optimistic projections.
2. Determine property value — Use the purchase price for a going-in cap rate, or the appraised/comparable-sale value for a market cap rate.
3. Divide NOI by property value — The result is the cap rate, expressed as a percentage.

Common Mistakes When Using Cap Rates

Cap rate is simple to calculate but easy to misapply. These are the most common errors investors and analysts make:

1. Using gross income instead of NOI. Gross rental income ignores vacancy, property taxes, insurance, and management fees. Using it in place of NOI vastly overstates the cap rate and makes properties appear more attractive than they are.

2. Including debt service in NOI. Mortgage payments are a financing cost, not an operating expense. NOI is an unleveraged metric by definition. Including debt service conflates property performance with capital structure decisions.

3. Comparing cap rates across different markets. A 7% cap rate in Manhattan signals a very different risk profile than 7% in a rural tertiary market. Cap rates are only meaningful when compared to similar properties in similar locations.

4. Ignoring capital expenditures. While CapEx is excluded from NOI by accounting convention, ignoring large upcoming expenses (roof replacement, HVAC overhaul, parking lot resurfacing) gives a misleading picture of actual returns. Always review the property condition report alongside the cap rate.

5. Treating cap rate as total return. Cap rate measures current income yield only. It excludes appreciation, leverage effects, tax benefits, and capital gains. A property with a low cap rate in a high-growth market may deliver superior total returns over a hold period.

6. Using un-stabilized NOI against market cap rates. Comparing a property with 40% vacancy to stabilized comps produces a misleadingly low cap rate. Either use stabilized (pro forma) NOI or explicitly adjust the comparison to reflect the property’s current condition.

7. Treating the asking-price cap rate as the market cap rate. The seller’s asking price is aspirational — it reflects what they hope to receive, not what the market will pay. The true market cap rate comes from comparable closed transactions, not listing prices.

Limitations of Cap Rates

1. Static — doesn’t model future changes. Cap rate assumes current NOI continues indefinitely. It cannot capture rent growth, vacancy fluctuations, or the impact of planned renovations on future income.

2. Ignores financing. Two investors buying the same property at the same cap rate will earn very different equity returns depending on their leverage. A 6% cap rate with 70% LTV financing at 5% interest produces a much higher cash-on-cash return than an all-cash purchase.

3. Doesn’t capture appreciation. A 4.5% cap rate in a high-growth market may generate superior total returns (income + appreciation) compared to an 8% cap rate in a declining market. Cap rate only measures the income component.

4. Market-dependent. Cap rates are only meaningful when compared to similar properties in similar markets. A 6% cap rate means very different things for multifamily in Austin versus office in Cleveland.

5. Unreliable for non-stabilized assets. Lease-up properties, value-add projects with volatile NOI, and management-intensive assets like hotels produce misleading cap rates because their income is unstable or heavily dependent on operational execution. For these property types, a discounted cash flow analysis provides a more accurate valuation.

For a complete CRE underwriting analysis, combine cap rate with DSCR (income coverage relative to debt service) and LTV (loan amount relative to property value). Together, these three metrics give lenders and investors a comprehensive view of property risk.