What Is a Cap Rate? Commercial Real Estate Explained Simply

A cap rate (short for capitalization rate) is the yearly net operating income a property produces divided by its value or purchase price. If a building earns $100,000 a year after operating expenses and sells for $1,250,000, its cap rate is 8%. It’s the quickest way commercial real estate people compare what a property earns against what it costs.

That’s the short answer to “what is a cap rate.” The rest of this post covers the formula, a worked example with round numbers, what the number leaves out, and why buyers argue about it so much. At the end, we’ll show where the same idea turns up when you play CRE Tycoon, our free commercial real estate game.

What is a cap rate, exactly?

Think of a cap rate as the yield a property would give you if you paid all cash. No mortgage, no clever financing, just the building’s income compared to its price.

That’s why it’s so useful. Two buyers might finance the same building in completely different ways, but the building’s cap rate stays the same. It describes the property, not the buyer.

The cap rate formula

The formula is short:

Cap rate = Net operating income (NOI) ÷ Property value (or purchase price)

You’ll see it written with “current market value” or with “purchase price.” When you’re analyzing a purchase, people usually use the price. When you’re estimating what a building you already own is worth, people usually use an estimate of market value.

What goes into NOI

The top half of the formula is net operating income. In plain terms:

NOI = Gross operating income − Operating expenses

Gross operating income is the rent and other property income you actually expect to collect, after allowing for vacancy and credit loss. Operating expenses are the costs of running the building: property taxes, insurance, repairs and maintenance, utilities the owner pays, management, and similar items.

NOI does not subtract:

• Debt service (loan principal and interest)
• Depreciation
• Capital expenditures, such as a new roof or a major system replacement
• Income taxes

We go deeper on this in our NOI explainer, because if the NOI is wrong, the cap rate is wrong too.

A worked cap rate example

Here’s a simple illustrative example. The numbers are round on purpose and aren’t meant to reflect any real market.

Say you’re looking at a small retail building.

1. Potential rent: $160,000 a year if every space is leased.
2. Vacancy and credit loss allowance: $10,000.
3. Gross operating income: $160,000 − $10,000 = $150,000.
4. Operating expenses: $50,000 (taxes, insurance, maintenance, management and so on).
5. NOI: $150,000 − $50,000 = $100,000.
6. Asking price: $1,250,000.
7. Cap rate: $100,000 ÷ $1,250,000 = 0.08, or 8%.

So at that price, the building earns 8% of its cost each year before any loan payments.

Turning it around: value from a cap rate

The formula also works backward, which is how appraisers and brokers often estimate value:

Value = NOI ÷ Cap rate

If similar buildings nearby recently sold at around a 7% cap rate, the same $100,000 of NOI suggests a value of $100,000 ÷ 0.07, or about $1,430,000. At 9%, it’s about $1,110,000.

Look at how far apart those are. Same building, same income, and a two-point swing in cap rate moves the value by more than $300,000 in this example.

Key takeaway: cap rate and value move in opposite directions. When cap rates fall, values rise for the same income, and when cap rates rise, values fall.

Why cap rates differ from building to building

If two buildings each earn $100,000 of NOI, why would one sell at a 6% cap and another at 9%? Because the cap rate is really the market’s price for risk and expected growth. Common factors include:

• Location. Buildings in strong, in-demand areas tend to trade at lower cap rates.
• Property type. Offices, retail, industrial and apartments each carry different risks. Our guide to commercial property types explains why.
• Tenant strength and lease length. A long lease to a financially strong tenant feels safer than a month-to-month tenant.
• Building condition. An older building that needs work usually prices at a higher cap rate to reflect the coming spending.
• Interest rates and the wider market. When borrowing costs and investor expectations shift, cap rates tend to shift with them, though not in lockstep.
• Expected growth. If buyers expect rents to rise, they may accept a lower cap rate today.

Is a high cap rate good or bad?

It depends on who you are. A buyer likes a high cap rate because they get more income per dollar. A seller likes a low cap rate because it means a higher price.

But a high cap rate is often high for a reason. It can signal vacancy risk, a shaky tenant, a tired building or a weak location. A low cap rate can signal safety, but it leaves less room for error if the income slips.

What a cap rate leaves out

Cap rates are a starting point, not a verdict. A professional will always look past the single number. Here’s what it doesn’t tell you.

Financing

Because NOI is calculated before loan payments, the cap rate says nothing about your actual cash flow with a mortgage. For that, investors look at cash-on-cash return (yearly cash flow after debt service ÷ the cash you put in) and the debt service coverage ratio (NOI ÷ annual debt service). Our refinancing guide explains both.

Capital spending

A building can show a healthy NOI and still need a new roof next year. Since capital expenditures sit outside NOI, you have to account for them separately, often by setting aside reserves.

The future

A cap rate is a snapshot of one year’s income. It doesn’t capture rent growth, a big lease expiring next year, or a planned renovation. That’s why analysts also build multi-year projections.

Whose NOI?

Always ask which NOI was used. A seller’s marketing package may show “pro forma” NOI, which assumes the building is fully leased at higher rents. The trailing NOI, based on what the property actually earned recently, can be much lower. A cap rate on optimistic income looks better than it is.

Going-in and exit cap rates

You’ll hear two more terms in deal conversations.

The going-in cap rate is the cap rate when you buy: your first-year NOI divided by your purchase price.

The exit cap rate is the cap rate you assume when you plan to sell later. Careful investors often assume a slightly higher exit cap rate than their going-in rate, to build in a cushion in case the market cools. Since value equals NOI divided by cap rate, a higher assumed exit cap means a more conservative sale price.

How cap rates show up in CRE Tycoon

CRE Tycoon is a commercial real estate tycoon game where you start as a broker and build up to owning a portfolio over a 10-year career. The game describes itself as “real CRE math, simplified,” and cap rates, NOI, loans, refinancing and market cycles are all part of that.

Here’s how the ideas in this article help you while you play:

• Comparing buildings. The game’s market has 275 buildings across four districts, including offices, retail, warehouses and apartments. Thinking in terms of income relative to price helps you spot which ones are worth a closer look.
• Reading the Deal Sheet. Before you buy, the Deal Sheet shows what you put in, what the building pays each month, and what the seller will likely say. That’s a compact version of the same question a cap rate answers: what am I getting for what I pay?
• Watching the market. The game models market cycles. In real life, shifts in the market show up partly as changes in cap rates, which is why the same building can be worth more or less in different years.
• Growing income. Leasing a building up and running business plans can raise what it earns. In real estate, higher income at the same cap rate means a higher value, which is the core of value-add investing.

The game simplifies on purpose, so a month fits in a coffee break. But the instinct it builds, comparing income to price and respecting risk, is the same one a real investor uses. Our CRE Tycoon how-to-play guide covers the full loop.

The bottom line on cap rates

A cap rate is NOI divided by value or price. It’s quick, it’s universal and it makes buildings comparable. It also hides financing, capital needs and the future, so treat it as the first question, not the last one.

If you’d like to practice thinking this way without risking a dollar, start a free career in CRE Tycoon and see how your instincts hold up over 120 months.

FAQ

What is a cap rate in simple terms?

A cap rate is a building’s yearly net operating income divided by its value or purchase price. It tells you what percentage of the price the property earns each year before any loan payments, as if you bought it with all cash.

Is a higher cap rate better?

Not automatically. A higher cap rate means more income per dollar of price, but it often comes with more risk, such as a weaker location, shorter leases or an older building. A lower cap rate usually means buyers see the income as safer or expect it to grow.

Does a cap rate include the mortgage?

No. Cap rate uses net operating income, which is calculated before debt service. That makes it a way to compare properties regardless of how each buyer finances them.

How do you find a property’s value from a cap rate?

Rearrange the formula: value equals NOI divided by the cap rate. A building with $100,000 of NOI at an 8% cap rate works out to $1,250,000 in this simple example.

What is the difference between cap rate and cash-on-cash return?

Cap rate compares NOI to the whole property price and ignores financing. Cash-on-cash return compares the cash flow after loan payments to the cash you actually put in, so it changes with leverage.

This article is for education and entertainment, not financial advice.